10 How to read ROE? Focusing on its drivers and sustainability.

Many US stock investors closely watch the indicator of return on equity (ROE), which calculates the amount of net profit generated per unit of net assets to measure a company's profitability.

As Charlie Munger once said, "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns." Companies with consistently high ROE may bring higher investment returns in the long run. Therefore, we must comprehend this indicator when investing in US stocks.

In this video, we'll be looking into two questions.

No.1: how can companies achieve a high ROE?

No.2, how do we evaluate the growth of ROE?

First, let's look at question No.1.

What are the drivers of high ROE?

It might be a good way to deconstruct and evaluate ROE through DuPont analysis.

DuPont analysis breaks down the components of the ROE formula into smaller parts to better understand how a company improves its profitability.

As we can see, the new formula is：

ROE = Net Profit Margin * Total Asset Turnover Ratio * Equity Multiplier

We can see that in this formula, net profit margin is a key profitability indicator.

The second component of this formula, the total asset turnover ratio, measures the company's operating capacity, while the equity multiplier is its leverage ratio.

Take Apple as an example.

The company's net margin for fiscal year 2022 was 25.31%, with a total asset turnover ratio of 1.12 and an equity multiplier of 6.18.

Apple's ROE for the fiscal year 2022 = 25.31% * 1.12 * 6.18 = 175.46%

By breaking down the ROE formula, we can see how a company maintains a high ROE exactly:

by relying on its profitable products or services, its management’s outstanding operating skills, or a high enough financial leverage.

Companies don't have to excel at all these aspects as their varying business models may offer unique advantages.

For example, a company in the software industry, such as Microsoft, may have a higher net profit margin.

Retail companies like Walmart may do better in total asset turnover.

Banks like Bank of America may have a high financial leverage.

Now let's move on to question No.2.

How to evaluate the growth of ROE?

We tend to look at its different components when analyzing companies with distinct business models.

For those with a high net margin, such as IT and pharmaceutical companies, their competitive landscape and the sustainability of their competitive advantage deserve attention.

A high net margin might indicate a low level of competition, or a deep moat, thanks to the company's brand awareness or technical capacity.

Yet if a company starts losing its competitive advantages, its net margin might come under pressure, which may in turn adversely affect its ROE.

For companies that rely primarily on a high total asset turnover ratio to maintain their ROE, including those in retail or Fast Moving Consumer Goods (FMCG) industries, we need to pay close attention to changes in its management.

That's because a high total asset turnover ratio requires sound inventory and supply chain management, and strong marketing strategies, which fall within the scope of the management team.

For companies that increase their ROE through higher financial leverage, such as those in the banking, energy, and real estate industries, we need to focus on their financial stability.

They can take on debt to secure higher returns when their industries are booming.

But once there's a downturn, their performance may get heavily affected and they may even suffer from financial distress.

So, of the three types of companies, which one may have a more stable ROE?

For companies with a high total asset turnover ratio, the management may change for various reasons.

Companies with high financial leverage are vulnerable to downturns in the economic cycle.

However companies with a higher net profit may have strong brand recognition, or they can upgrade technologies and economies of scale with reinvested profits, maintaining their competitive advantages.

Therefore, relatively speaking, a profit-driven ROE might be more sustainable.

To sum up, the higher the ROE, the higher the potential return on investment in the long run.

There are several possible reasons behind a higher ROE, including a high net margin, a high total asset turnover ratio, and a high financial leverage.

Companies with a consistently high net profit are likely to maintain a high ROE.