A good Fund Manager always goes behind the apparent numbers to bring out the essence out it. They are the educated sleuths, going through minute details and footnotes to find out any meaningful information.
They often use a simple method of analysing the levers the management has to enhance the profitability of the company in the future. It is known as Du Pont analysis, started by the company way back almost 100 years ago in 1920s to analyze performance.
Return on Equity (ROE)= Net Income/Total Equity
A higher ROE is always desirable by the investors as it shows that the return generated by the company on the Shareholder Equity is increasing. Now, Net Income could also be boasted by taking more loan keeping the denominator constant, but over-leveraging impairs the balance sheet and cash flows resulting in a debt trap. This makes the stock risky. To avoid this kind of pitfalls in assumption a more detailed analysis is necessary.
In Du Point analysis this equation is expanded to make it more meaningful:
ROE= Profit Margin( Net Income/Sales)*Asset Turnover(Sales/ Asset)* Leverage(Asset/Equity)
We have broken down the equation into net profit margin (the margin it earns per unit of sale), the usage of its assets in asset turnover and Asset out of Equity indicating the leverage level of the company.
If the increase in ROE is due to increasing profit margin that is a welcome move, though investors should be decipher whether the increase is due to cost reduction (as is the case post 2008) or it is due to pricing power enjoyed by the company as the former method has finite limits.
An increase in ORE due to enhanced Asset Turnover is good as company is utilizing more of its asset effectively, but it cant be extended beyond a point as production capacity has a limit.
The last entity gives an idea about the leverage of the company. So it is a danger signal if the ROE increases only due to this as it increases the risk and the valuation should reflect the concerns despite posting higher ROE.
Reading Between The Lines
A simple ratio analysis does not help us to identify the areas the company is lagging. It also shows us the areas the company is lagging or the way it is propping up the number. It also let us know whether the company has adequate ammunition to influence the above parameters.It broadens our understanding of a basic equation.