A Look At 1 Important Investing Formula For Dairy Farm International Holdings Ltd

The return on equity (ROE) metric measures a company’s ability to generate a profit with the shareholders’ capital it has. Generally speaking, a high ROE is preferred over a low one, all things being equal.

Here’s a chart to illustrate how Dairy Farm International Holdings Ltd’s (SGX: D01) ROE has changed over its last five fiscal years.

Source: Dairy Farm’s annual reports

Dairy Farm is a retailer with stakes in around 6,500 outlets around Asia. It has four main business segments: Food, Health and Beauty, Home Furnishings, and Restaurants. Brands such as Guardian, Cold Storage, Giant, and even IKEA fall under its vast umbrella.

The ROE chart above looks at the net profit for the year, excluding other more volatile variables such as exchange translations ( the company reports in the US dollar but conducts business only in Asia). As you can see, Dairy Farm’s ROE has declined from over 50% in 2011 to ‘just’ less than 30% (28.7% to be exact) in 2015.

Why has this happened? A company’s ROE can actually be broken down into greater detail to provide even more useful insight. Here is the breakdown:

ROE = Profit Margin x Asset Turnover x Equity Multiplier

Some of you may find the formula familiar: It is actually the DuPont formula created by the DuPont Corporation in the 1920s to measure its own internal efficiency.

So what can the DuPont analysis tell us about the changes in Dairy Farm’s ROE from 2011 to 2015? Let’s start with the first component, the profit margin:

Source: Dairy Farm’s annual reports

The chart just above show that Dairy Farm’s profit margins have been squeezed over the years, falling from 5.3% in 2011 to 3.7% in 2015. Competitive forces could have been at play, such as those from online retail players.

To fend off competition, Dairy Farm’s chief executive Graham Allan is focusing the company’s Food segment on fresh produce, an area where online retail players have struggled. Apart from the fresh produce strategy, Dairy Farm is also trying to bring its other offerings online – for instance, its IKEA stores have started online shopping.

Source: Dairy Farm’s annual reports

The second component of the DuPont formula, the asset turnover, is a measure of how good Dairy Farm is at utilizing its assets to generate revenue. It is calculated by dividing the company’s revenue with its assets. Generally, a higher asset turnover translates to a better performance.

We can see that Dairy Farm’s asset turnover has been fairly consistent, falling between 2.3 and 2.6 in the past five years. The company’s revenue and total assets have both increased proportionately.

The last component of the DuPont formula is the equity multiplier and it is found by dividing a company’s assets with its equity. It is a gauge for how much leverage – and thus financial risk – Dairy Farm is taking on. Generally, higher leverage results in better return on equity but at the expense of a weaker balance sheet.

As the chart above shows, Dairy Farm’s equity multiplier was coming down from 3.8 in 2011 to 2.8 in 2014, but then made a U-turn in 2015 to return to 3.3. That said, the equity multiplier in 2015 is still lower than that in 2011 and it partially accounts for Dairy Farm’s lower ROE in recent years. The high equity multiplier has also driven Dairy Farm’s ROEs of over 25% in recent years.

A Fool’s take

To sum up, the DuPont analysis has showed us that Dairy Farm’s ROE is driven by the high leverage it takes on. The decline meanwhile, is largely the result of lower profit margins and the equity multiplier.

It should be noted that more work needs to be done beyond the DuPont analysis before any firm investing conclusion can be made on Dairy Farm. This look at the company’s ROE should only be seen as a useful starting point for further research.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of Dairy Farm International Holdings. Motley Fool Singapore contributor Wilson Ong doesn’t own shares in any companies mentioned.