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Is all really well with high RoE companies? - Views on News from Equitymaster
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  • Apr 14, 2012

    Is all really well with high RoE companies?

    In our first article of this series, we introduced the DuPont method as a key technique for analyzing the performance of companies to invest in.

    While investors systematically study fundamentals, we highlighted that there can still be gaps in their assessment. The DuPont method focuses on dissecting the important Return on Equity (RoE), and provides invaluable insight regarding the company's strategy, operations and financial health.

    Specifically, this DuPont analysis examines the important RoE (Net Profit/Equity) through three components which are:

    • Operating efficiency, measured by profit margin (Net Profit/Sales)

    • Asset use efficiency, measured by total asset turnover (Sales/Total Assets)

    • Financial leverage, measured by the equity multiplier
    Put in equation form,

    RoE (Return on Equity) = (Net profit margin) * (Asset turnover) * (Equity multiplier) OR

    RoE = Net Profit/ Equity = (Net Profit/ Sales) *(Sales/Total Assets) * (Total Assets/Equity)

    In today's article we will look at the BSE 500 companies with the highest RoEs to and try and understand the which of the above three drivers largely contributed to the positive results.

    BSE Index high RoE companies - A closer look

    From the BSE 500 companies, we identified the top 15 with the highest RoEs. The table below, focuses on 7 of these companies, and shows that each of these has different components that drives their RoE.

    RoE - Key drivers differ by company
    Company RoE Net Profit margin Asset Turnover ratio Leverage
    Colgate-Palmolive (India) Ltd. 131% 22% 5.9 1.0
    Piramal Healthcare Ltd. 109% 513% 0.2 1.1
    Hindustan Unilever Ltd. 85% 12% 7.2 1.0
    Nesco Ltd. 52% 33% 1.4 1.2
    eClerx Services Ltd. 51% 36% 1.4 1.0
    Tata Motors Ltd. 48% 8% 2.4 2.7
    Havells India Ltd. 46% 5% 3.3 2.7
    All the numbers are for the year ended 2011

    We have used Year ending 2011 numbers to illustrate the value of the DuPont approach. However, investors should consider the past three to five year trends for the RoE and each of its three components.

    From the table, FMCG Companies Colgate Palmolive and Hindustan Lever, have the highest RoEs of 132% and 85% respectively (Piramal Healthcare is a special case which we discuss later). These high RoEs are a result of huge asset turnover ratios of 6 and 7 times respectively. Incidentally, these companies also have the highest asset turnover ratios amongst all BSE 500 companies. In general, FMCG companies operate on relatively lower asset bases, and these two companies clearly outperform their peers by "moving" and turning over their goods fast with relatively few assets. It is also likely that FMCG companies are less prone to economic downturns than other industries.

    In the table, Nesco and eClerx have the next highest RoEs with 52% and 51% respectively. In their case, it is their net profit margins (33% and 36% respectively) which are the critical contributors to their high RoEs. Their profits seem to be arising from their ongoing business, and do not include any extra ordinary income. If their net profit margin three to five year trend is stable, we can expect consistent RoEs from these companies.

    Then, from the table, we see that Tata Motors and Havells India have been able to generate high RoEs of 48% and 46% respectively. And, this performance is driven, not by high profit margins, nor elevated asset turnover, but because of their huge financial leverage. Essentially they have borrowed heavily to support their growth strategy. This also implies that they have a relatively high fixed interest cost obligation, which represents a major risk to these companies. We may recollect here that Tata Motors had acquired Jaguar Land Rover around four years ago, and this dramatically increased its debt obligations.

    Piramal Healthcare deserves special mention. For Piramal Healthcare, their huge 513% profit margin resulted in a high RoE figure of 109%. However, know that Piramal's net profits include an extraordinary profit due to the sale of it's healthcare business, and one of its subsidiaries Piramal Diagnostic Services Private Limited. So Piramal Healthcare's 109% RoE is not truly indicative of the company's "health", nor its sustainability.

    The DuPont method has provided us with meaningful insights. Each of these companies and their RoEs is driven by a distinctive component. If profit margins are the key, this can connote operational strength and stability. If asset turnover is the main contributing variable, it can be because the company is efficiently using it assets (with good operation and relatively fewer assets). Finally, if financial leverage (equity multiplier) is the core facilitator of RoE, this can indicate a growth strategy undertaken with high risk. Clearly, with the DuPont approach, we know more than just the fundamentals, and now have some answers, and importantly, new questions to help making investment decisions.

    Our next article in this series to examine the DuPont method, we will scrutinize BSE companies that have the lowest RoEs. And we will use the DuPont analysis to guide us to understand the reasons behind such low numbers, and if there is "silver" lining somewhere.



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