Uncovering a company’s earnings power

Thursday, June 23rd, 2016

Du Pont analysis is a simple way to uncover the drivers of or return on equity. Return on equity plays a vital role within Clime’s investing methodology and represents a company’s earnings power. It’s the amount of profit a company generates relative to the amount of shareholders’ capital added to the business via equity raisings and retained earnings.

Companies with higher returns on equity are worth more, all else equal, especially if they have higher reinvestment rates.

High return on equity is a desirable metric, but it comes with a few caveats.

Firstly, return on equity tells us more about a business when it is tied to operations, as opposed to externalities such as commodity prices. The long term average is about 10%, which is the approximate hurdle rate for corporations to invest. Unusually high returns attract competition and normally get competed away unless the business has a strong sustainable competitive advantage.

Perhaps a good question to ask when you’re looking at a high ROE company is, does the attractive profitability reflect a consumer monopoly? Such businesses dominate their market because they do something others can’t easily replicate and their high rates of return are more likely to be sustained, allowing the magic of compounding over time.

Secondly, although high ROE suggests superior business economics, the direction and future expectations of ROE are often more important determinants of investment performance. This applies in the cases of both high-quality and low-quality businesses. A high ROE business can still make a poor investment if profitability is declining. A recent example is BHP, a major miner with advantages including industry-leading costs of production and long-life assets, whose share price more than halved over the last year as profitability forecasts were downgraded on an increasingly bearish outlook for commodity prices.

And thirdly, the performance of commodity-type businesses is less predictable so they can’t be valued with confidence. This is dealt with quantitatively in StocksInValue by using conservative assumptions for profitability and higher required returns, which reduce valuations.

In short, ROE can be deceptive if viewed on its own.

Du Pont Basics

Du Pont analysis gets its name from the Du Pont Corporation, which first used technique to analyse its operations in the 1920’s.

The three-component Du Pont formula splits ROE into the margin earned on sales (or net profit margin), the ratio of sales to assets (or asset turnover), and the ratio of assets to shareholders’ equity (or financial leverage). Using this analysis we can see the extent to which a business’s profitability is driven by the profitability of individual sales, the volume of sales, or leverage.


Figure 1. Three-component Du Pont formula
Source: Clime & StocksInValue

 

The five-component Du Pont formula further splits the net profit margin into EBIT margin, interest burden and tax burden components.

Figure 2. Five-component Du Pont formula

 

Below I’ve included a Du Pont analysis of three companies that each reported above-average profitability in FY15. They are ARB Corp, Woolworths and Qantas. As you’ll see, although they generated similar respective returns on equity of 21%, 24% and 17%, however, as Du Pont reveals, they have very different economic drivers.

Case Study: Example 1. ARB Corp

ARB’s ROE reveals a strong net profit margin is the main driver of profitability. The high margin reflects ARB’s pricing power as the go-to brand in Australia for four wheel drive accessories (bull bars, suspension, roofracks, etc). These products are simple in nature and can be easily replicated, however trust in the ARB brand drives a consumer monopoly in the Australian market. A question is whether ARB can achieve the same brand power as it expands into the Europe and US and thus maintain profitability at historical levels.

Figure 3. Du Pont ROE composition for ARB Corp
Source: Clime & StocksInValue

Case Study: Example 2. Woolworths Limited

Next is Woolworths, whose high asset turnover compensates for low margins on sales to generate strong profitability. WOW and Coles should continue to dominate the Australian grocery market and maintain share due to their distribution network, which is difficult to replicate, however the question is whether WOW will experience the same fate as European peers, whose margins almost halved as discounters Aldi and Lidl took share by competing on price. WOW’s world-leading margin may prove an easy target for the new entrants.

Figure 4. Du Pont ROE breakdown for Woolworths
Source: StocksInValue

Case Study: Example 3. Qantas Limited

And finally Qantas’s high ROE in FY15 was largely driven by relatively high leverage and lower oil prices. Commenting on the notoriously poor economics of airlines Virgin boss Sir Richard Branson once said “if you want to be a millionaire, start with a billion dollars and launch a new airline”.  Due to the commoditised nature of air travel, profit margins are weak and asset turnover is slow due to the high capital expenditure requirements of maintaining a fleet of aircraft. So we can clearly see here Qantas’s poor return on assets translates to reasonable return on equity (in a good year) via leverage.

Figure 5. Du Pont ROE break-down for Qantas
Source: Clime & StocksInValue

Written by Jonathan Wilson, Equities Analyst.

5 Responses to “Uncovering a company’s earnings power”

  1. Doug Andersen says:

    Very good article. Thank you

  2. Des Sandercock says:

    A useful tool thank you.

  3. Omihi says:

    I note the ROE for ARB has been consistently declining since 2010, what is going on there?

  4. Michael says:

    Good article and a salutary reminder to all investors to look and understand the financials. It mightn’t be trendy but it’s worth the effort.

  5. Andy says:

    interesting ratio but not to be used by itself, as high ROE and also point to a highly under-capitalised business (low earnings but even lower capitalisation gives high ROE). Businesses which are highly leveraged / thinly capitalised aren’t always a good long term bet.

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