"In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the
best businesses by far for owners continue to be those that have high returns on capital and that
require little incremental investment to grow. We are fortunate to own a number of such businesses,
and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing
amounts of cash, we are today quite willing to enter businesses that regularly require large capital
expenditures. We expect only that these businesses have reasonable expectations of earning decent
returns on the incremental sums they invest. If our expectations are met and we believe that they
will be Berkshire's ever-growing collection of good to great businesses should produce aboveaverage, though certainly not spectacular, returns in the decades ahead."
Warren Buffet, Letter to shareholders, 2009.
Investors use return on equity (ROE) to measure the earnings a company generates from its assets.
With it, you can determine whether a firm is a profit-creator or a profit-burner and managements
profit-generating efficiency. Why is this important to investors? Companies that are good at coaxing
profits from their operations tend to have competitive advantages, which can translate into superior
investment returns. In its simplest form, return on equity is calculated as follows:
ROE = Net income / Shareholders equity
Shareholders equity is also called book value, which is the difference between total assets and total
liabilities. It may be more accurate to use the average equity at the beginning and end of the year for
the above computation. It is obvious that the higher a companys return on equity, the better
management is at employing investors capital to generate profits.
The above formula indicates that the management may generate high net income, but it is not
necessary that it is efficient if it is utilizing high amount of equity, and vice versa. If a company generate
RM100m of profit with RM2 billion from shareholders fund, or an ROE of 5%, it is not good; whereas
a company earns RM10 with only RM30 m from money foot in by shareholders, or an ROE of 33%, the
management is doing a great job.
However, relying on the formula above to derive return on equity tells an incomplete story about a
company. For example, a company can boost its ROE by taking on additional debt. If its debt load
becomes excessive, it may force the company into bankruptcy. As a result, it is a good idea to examine
the drivers of ROE. In order to do that, E.I. du Pont Nemours and Company came up with a system to
deconstruct ROE. Over the years, this system has become known as the DuPont model.
The three-step DuPont model, in effect, captures managements effectiveness at generating profits
(net profit margin), managing assets (asset turnover) and finding an optimal amount of leverage
(equity multiplier).
Ideally, we would like to see a company boosting its ROE by increasing its net margin or its asset
turnover.
Asset Turnover
Asset turnover measures how much sales a company generates from each dollar of assets. It allows
us to gauge managements effectiveness at using assets to drive sales.
The majority of high-margin companies also tend to have low asset turnover. This is because a firm
can only do a certain amount of business without incurring additional costs that would adversely
impact profit margins. On the flip side, low-margin firms tend to have high asset turnover, as they rely
on high sales volume to generate profits. By improving its asset management policies, a company can
boost shareholder returns without necessarily increasing profit margins.
Equity Multiplier
The final component of the three-step DuPont Model is the equity multiplier, which is a measure of
financial leverage. It helps us examine how a firm uses debt to finance its assets. A higher equity
multiplier indicates higher financial leverage, which means the company is relying more on debt to
finance its assets.
A company can boost its ROE by raising its equity multiplier (increasing the amount of debt it carries).
If a company is already sufficiently levered, taking on additional debt increases the risks of not being
able to fulfil its obligations to creditors and going bankrupt.
2014
#000
#000
#000
#000
Pintaras
201907
54,238
383522
307256
Kimlun
1,219,714
49,182
915249
404262
*=NI/Revenue
*=Revenue/Total assets
*=Total assets/Total equity
26.9%
0.53
1.25
4.0%
1.33
2.26
*1*2
*=1*2*3
14.1%
17.7%
5.4%
12.2%
The first measurement for efficiency in managing the assets of the company is the Return on Assets.
The ratio ROA gives an idea of how efficient management is at using its assets to generate profit. It is
clear from the table above that Pintaras has achieved a higher ROA of 14.1% than the 5.4% of Kimlun.
The higher ROA for Pintaras is generated with its high net margin of work of 26.9%. Kimlun, with a
much higher asset turnover of 1.33, meaning it has a lot more work to do, didnt manage to produce
good ROA due to its thin net profit margin of just 4%. Generally a ROA of more than 10% in the
construction industry shows the managements ability to manage its assets efficiently, and ROA of less
than 5% is poor.
It is also clear that the next measurement of efficiency, ROE of Pintaras of 17.7% is much more superior
compared to that of Kimlun of 12.2%. The higher ROE of Pintaras was achieved again with a very high
net profit margin of 26.9%, the most desirable way to achieve a higher ROE. Few construction
companies have their net profit margin in double digits, not to say anywhere close to that of Pintaras.
Furthermore the higher ROE was also achieved with much lower equity multiplier or financial leverage
of just 1.25 compared to relatively high financial leverage of 2.26 of Kimlun which has total debts 0.44
time its equity.
Pintaras is a debt free company. In fact it has too much cash in its balance sheet. Hence it hardly
leverages itself to do business. In order to increase its financial leverage and improves its ROE, one
thing Pintaras can do is to distribute all its cash and cash equivalent of RM1.05 per share to the
shareholders, as special dividend! This will have minimal effect on its healthy balance sheet. It can
even recapitalizes its balance sheet with some debts by borrowing some money from the bank if
requires, further increases its financial leverage, and hence its ROE. However, this is the prerogative
of the management who should know better of what is best course of action for the company.
Pintarass annual turnover of RM202 m is however, pale in comparison with the RM1220 m of Kimlun.
The asset turnover of Kimlun at 1.33 times is more than two and a half times that of Pintaras of 0.53.
In contrary, the ROE of Pintaras is still way above that of Kimlun.
The DuPont Analysis of dissecting the ROE of Pintaras and Kimlun shows that Pintaras has a higher
ROE of 17.7%, one which is higher than its cost of equity. It was also achieved with the more desirable
mean, i.e. the high profit margin coupled with low financial leverage. Kimlun, despite having higher
asset turnover and financial leverage, and hence higher debt and more risky as a result, was only able
to achieve a ROE of just 12.2%, much lower than that of Pintaras and one even below its cost of equity.
Conclusions
It can be seen from the above example that ROE, and dissecting ROE, tells investors so much more
than a simple revenue and EPS number. ROE gives investors a glimpse at the managements efficiency
in making profits in utilizing its assets, not just simply how much is its revenue or how much it earned.
ROE gives insights on the companys margins, revenue, retained earnings and much more.
DuPont Analysis of ROE is just a way to determine which company in the same industry has a better
management efficiency, and hence a better company. Always bear in mind that a better company is
not necessary a better investment. We will have to look at its market valuation which is in the later
part of the course.