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What's ailing the low RoE companies?

Apr 17, 2012

In our first article of this series we introduced the DuPont method as a key technique used in analyzing companies as prospective investments.

While investors systematically study fundamentals, we highlighted that there can still be loopholes 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, the 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)

Dissecting BSE high RoE companies

In our second article of this series, we closely studied BSE 500 companies with the highest RoEs, and illustrated the value of the DuPont method. For investment decisions, we learnt that the RoE of each of these companies is driven by a distinctive component.

In today's third and final article on this series on the DuPont method, we look at the BSE 500 companies with lowest RoEs. What are the reasons behind their undesirable results? For our analysis, we omitted companies that generate negative RoEs.

BSE Index low RoE companies - A closer look

Amongst the BSE 500 companies with the lowest RoEs, we considered 6 for our in depth analysis, and to demonstrate how the DuPont method can be of help.

The table below shows that the RoE and its three components for each of these companies

BSE Low RoE Companies - Key causes differ by company
CompanyRoENet Profit marginAsset Turnover ratioLeverage
Indiabulls Power Ltd.0.1%1366.1%0.001.25
Max India Ltd.0.5%0.1%0.439.26
Bajaj Hindusthan Ltd.0.7%0.4%0.404.34
KGN Industries Ltd.0.9%18.2%0.051.00
MMTC Ltd.1.7%0.0%8.934.97
Jaiprakash Power Ventures Ltd3.1%22.0%0.043.66

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, we observe that most of the companies with low RoE have abysmally low net profit margins of 1% or even lower. In the table, Max India, Bajaj Hindusthan and MMTC Limited have RoEs ranging from 0.5% (Max India) to 1.7% (MMTC). For all three companies, their net profit margins are less than 1%. Also, for the past three years, the performance of all three companies has been poor, both, in terms of operating profits as well as net profits. Note that, although MMTC has a potentially positive high asset turnover ratio of 8.9, and Max has a possibly "risky" high leverage of 9.3, their ultra low net profit margins significantly drop their RoEs.

Interestingly, Jaiprakash Power Ventures and KGN Industries have a good net profit margin of 22% and 18% respectively, Jaiprakash even has a high financial leverage of 3.7. However it's RoE is still really low at 3.1%. This is because of its extremely low 0.04 asset turnover ratio. This tells us that it has relatively large assets, or that sales are made over a long period of time.

Strangely, despite Indiabulls Power whopping net profit margin of 1366%, the company has managed a RoE of only 0.1%, the lowest amongst all BSE companies. This is because of its unbelievably low and negligible (0.0) asset turnover ratio. The reason for such a high net profit margin lies in the fact that the company earns substantial other income in the form of interest on deposits. A closer look reveals that at the operating level, the company actually incurs losses. Why is this? Does this indicate a poor investment? Or, maybe it is because the company started in 1997, and being a power company, it still has to create traction and adequate revenues and returns. The Dupont method also raises such questions.

In our previous article we had mentioned the risk associated with a high RoE company if the financial leverage is too high. This situation results in increased interest obligations for the company. In today's article, we notice through with Max India Ltd., that even with "risky" high leverage, companies can still have low RoEs due to low profit margins or a low asset turnover.

DuPont Analysis - The Power of the Method

From our three articles in this DuPont method series, we know that in addition to systematic fundamental analysis, the DuPont approach will enable you to unearth facts that are not so obvious.

From our review of the BSE companies with both high as well as low RoEs, we believe that sustainable RoEs are generated out of higher net profit margins, and higher asset turnover ratios, or a combination of both. 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, and a continuously looming interest burden.

So, though BSE companies that generate high RoEs are worth considering as investments, a closer look using the DuPont method unveiled the RoE.

Essentially, the DuPont equation helped us extract rich information to see the overall strategy, and to identify which distinctive RoE component had been instrumental in enabling the company to earn sustainable returns for its equity shareholders. And, for companies with unsatisfactory RoEs, the DuPont analysis helped locate that part of the business that is underperforming and destroying wealth.

The DuPont approach with its triangulation, shed new light, and raised important questions. And it provided a meaningful guide to select which companies to invest in.

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