Does Having a High RoE Makes a Company a Sure Buy?
Like the Dividend Yield, a high RoE is not a “sure-win” sign to invest in a company. It can be broken down into 3 separate ratios for further analysis, to justify whether a high RoE is good or not. What are the 3 broken down ratios?
Choon Beng: Hi, I’m Choon Beng. Together with me is Joo Parn, we are from MyKayaPlus.This is our second video! Today we’ll be discussing the DuPont analysis. So what is DuPont Analysis? Maybe Joo Parn you can start it off with the definition?
Joo Parn: Sure! Hi everyone! So, DuPont analysis actually is the breakdown of Return On Equity into 3 subcategories. Basically, it zooms down to analyze the Profit Margin, the Assets Turnover and Financial Leverage. So you can see there in the formula, you have your net profit over sales and multiplied with the sales over the total assets and after that, you multiply it again with total assets over the equity
Choon Beng: Yup! So we will get the Return on Equity if we multiply all 3 items together, which eventually will become the net profit over the shareholder’s equity. But you might be asking us why do we need to zoom into so detailed? Isn’t it a high RoE a straightforward sign that the company is a good company to invest in?
Joo Parn: Not necessarily though. The RoE and the DuPont analysis should be used as tools to analyze a company, not a key decision-making point! So you all shouldn’t be making any investing decisions just purely based on a company’s high RoE0
Choon Beng: Yup. So if you take a look on this slide, just imagine if you are the owner of this cafe. DuPont analysis is actually one of the best ways to measure your business performance easily. So the first aspect is the profit margin. You should check how much are you earning per item served. Second, what is the daily average occupancy of your cafe space? Is it always full or is it your chairs, your space or the tables are well utilized? This will correlate to your assets turnover. Lastly, it is about financial leverage. Whether your cafe is taking loans or borrowings to expand or scale your business strategically. Okay Joo Parn, maybe we should come up with some examples to show our viewers. Maybe it’s a good idea to use a Mamak stall as an example because I’m really missing the time where I can enjoy my supper at the Mamak stall. But now it’s the lockdown period. I cannot go out
Joo Parn: Okay! Okay! Sure alright. Here’s an example of 3 Mamak stalls. We will do a DuPont analysis on them. So let’s compare 2 Mamak restaurants to show how a DuPont analysis can differentiate the two companies respective performance. So we have two sample restaurants: Original Penang Kayu Nasi Kandar and also Nasi Kandar Pelita
Choon Beng: Yup. From the slide, you can see both Mamak stalls are having the same annual sales amount of RM 2 million. However, Kayu is having a higher ROE. So the direct assumption that most of the people will make is the one with higher RoE is a better company, right?
Joo Parn: By looking at the RoE itself purely, yes. But when you look into the financial leverage, you will see that Pelita has higher equity, while Kayu has a higher gearing ratio due to lower equity.
Choon Beng: Yes in another word, Kayu has more liabilities if compared to Pelita
Joo Parn: Yes, you are right. Since assets equal to liabilities plus equities we have to look deeper to check whether the liabilities of Kayu is made up of payables or borrowings
Choon Beng: Yes, just imagine Kayu take loans to grow their business, then they will be heavily impacted during a lockdown time like this. Hence, when we do company analysis, we have to ensure that companies have enough liquidity to pay off their liabilities before investing!
Joo Parn: Yes spot on! So, imagine if you didn’t check the liabilities of Kayu and you invested in this company purely based on the high RoE. And during difficult times like this, the company may face cash flow problems. Sales will definitely be impacted but they still have to pay bills and also worker salaries!
Choon Beng: Yes, it can become very scary if it happens to a listed company. So, for example, there is a company called Sapura Energy Berhad. They used to face liquidity issues until they had to make a cash call by diluting the outstanding shares. This action itself make their share price become cheaper because when there are more shares in the market, the supply goes up while the demand remains the same. Of course, the share price will drop. So as a result, when investors saw a huge drop in share price, it will trigger another action which is panic selling and cause the share price to drop further. Can you imagine a company like Sapura that used to trade at RM4 can go down to RM0.07 because of all this?
Joo Parn: Yes, that’s a good real-life and scary example on why we should always, always check the gearing of a company before we invest in it! Another reason why DuPont analysis is very, very useful is to compare companies that have the same RoE. We can drill down further to single out which of the company is actually better by just doing the DuPont analysis.
Choon Beng: Yes. So now we have another Mamak together with Pelita. The other Mamak is called SS2 Murni. So you can see both them are having the same RoE, which is 50%, but you can see the profit margin from Murni is actually much higher! In simple term, Murni can earn more than Kayu by selling the same amount of Roti Canai!
Joo Parn: Yes, yes! You are right! Not only that, but you can also notice that Murni is also able to generate more revenue per asset! t can generate 25% more with the same amount of assets if you compare SS2 Murni’s Assets Turnover versus Nasi Kandar Pelita
Choon Beng: Yup and look! Murni has no liabilities as their Assets is equal to Equities. But of course, this can’t be real in the actual world. Where in the world business doesn’t have borrowings or payables?
Joo Parn: (laughs) Yes we are using a fictional company as an example. But you’re right. Murni can generate higher profits. It can also generate more sales with the same amount of assets. So it has a higher potential to grow at a faster rate when they eventually try to take in some borrowings to further grow their business. So even though Nasi Kandar Pelita & SS2 Murni both have the same RoE, I would definitely think that SS2 Murni is the better company just by doing this DuPont analysis. Choon Beng: Yes. so the next time when you look at the RoE of the company, remember to always break it down into 3 aspects so that you can have a better picture of the company. Remember, every aspect matter. An ideal company that will give a high return is either they are having a high-profit margin or they are having a high asset turn over and also depends on whether they leveraging on financing as well
Joo Parn: Yup. You are right. Absolutely correct. And we hope we share something that is useful to you. Please give us your feedback or do you have any questions? Let us know in the comments section or even what are the next topics to talk about in our upcoming videos.
Choon Beng: Yes, don’t forget to like and subscribe ya! And if you haven’t check out our first video on tricks to justify high P/E ratio stocks you may click here to check it out. So I think that’s all for today. We will be checking out. Bye~!
Joo Parn: Bye Bye~!
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