When measuring a company's profitability, it is generally useful to have a measuring stick that you can use to compare the earnings delivered by firms of various sizes. For example, it is quite possible for a large company that generates $1 million in annual net income to be only modestly profitable, while a tiny micro-cap firm that produces just $100,000 in yearly income could be considered enormously profitable. Obviously, comparing just the profits -- $100,000 and $1 million -- in isolation only tells us part of the picture.

While there are a number of financial measures that could also be used to assess a company's overall profitability, one of the most revealing is return on equity (ROE). The following calculation is a simple method of determining how much net income a company generates per dollar of shareholders equity.

ROE = Net Income/Shareholders Equity

Returning to the previous example, let's dig deeper into the small company (ABC) and the large company (XYZ). 

Suppose ABC reported total equity (assets - liabilities) of $400,000 last quarter, while XYZ reported a comparable figure of $10 million. With this information, we can now calculate the ROE for each. 

ABC -- $100,000/$400,000 = 25% 
XYZ -- $1,000,000/$10,000,000 = 10% 

By using ROE, we discover that while XYZ can be expected to generate far greater profits than ABC in absolute terms, the company is much less efficient relative to its level of shareholder equity.

A company that shows repeatedly poor ROE figures is likely to be struggling. Conversely, if a firm routinely churns out above average returns on equity -- particularly if ROE is holding steady or rising -- then it is a good sign that management is running the company efficiently. However, by the time a company's success is reflected in improving ROE figures, any improvements have probably already been priced into the shares.

They key to being a successful value/contrarian investor lies in recognizing those companies that are poised to generate stronger financial results before the rest of the public can see any improvements. You can accomplish this by breaking down ROE into the components that influence the calculation and examining them individually. Often, this will tell you that a company is heading in the right direction before ROE (and the stock) begins to climb higher. 

There are three main drivers of ROE: profitability, productivity, and capital structure. The finance department at DuPont identified these components as profit margins, asset turnover, and financial leverage. Hence, a derivative of these inputs is known as the DuPont formula. When a company is doing the right things for shareholders, it is common to see improvements in each of these three areas. Naturally, companies with stronger returns on equity -- all else being equal -- should be assigned higher intrinsic values.

Too many investors make the mistake of keying exclusively on sales and earnings and ignoring nearly everything else. After all, what good are buckets of earnings if management foolishly squanders the profits with ill-advised capital allocation decisions? Furthermore, even the strongest earnings growth can be watered down with excessive options dilution. Impressive growth rates may capture the headlines and prop up a stock's price temporarily, but in the long run it will be impossible to sustain if the capital structure is weakening and/or management does not manage shareholders' capital effectively. For this reason, legendary value investor Warren Buffett and others rely heavily on management efficiency when evaluating prospective investments. 

It should be reiterated, though, that ROE by definition is a backward-looking tool based on past performance. While this information is useful, a company's future direction is always of greater importance. To better understand where a firm might be headed, it is essential to analyze the underlying factors identified by the DuPont formula.

Before we go further, it's worth taking a moment to discuss the impact of debt. There is nothing inherently wrong with leverage, provided management can put the money to good use. In some cases, though, debt can be used to distort the ROE picture. Furthermore, excessive debt can create numerous problems, not the least of which is mounting interest payments that can offset earnings growth. Thus, there is a marked difference between a debt-free company with an ROE of 20 and a highly leveraged one with an identical ROE. For this reason, the ROE formula should be tweaked for debt-laden companies. The revised formula, known as Return on Total Capital (ROTC) or Return on Invested Capital (ROIC) is as follows:

ROTC = Net Income/(Owners Equity + Long-Term Debt)

Getting back to the DuPont formula, ROE is a function of profit margins, asset turnover, and financial leverage. Specifically, the formula looks like this: 

ROE = (PROFIT/SALES) x (SALES/ASSETS) x (ASSETS/EQUITY) 

From a simple algebraic point of view, the sales figure is found in both the numerator and denominator and is thus cancelled out. The same goes for assets. That leaves profits and top and equity on bottom -- or Net Income/Equity.

Profitability = PROFIT/SALES

Productivity = SALES/ASSETS 

Capital Structure = ASSETS/EQUITY

Looking at each of these three components separately may reveal which direction the company is headed before the changes show up in ROE -- thus keeping us one step ahead of the public.

Let's start with the first of the three components -- profitability. To make an educated assumption about which direction a company's profits are headed, it is important to examine such factors as gross margins and selling, general, and administrative (SG&A) expenses. Ask yourself some important questions: Has the firm's product mix improved? Are margins in line with the industry? Are they expanding or contracting? Is SG&A increasing or decreasing as a percentage of sales? These types of questions are a good starting point to assess future profitability.

Next, it is time to look at productivity, or asset turnover. This measures how well the company is using its assets to generate sales -- and by extension profits. It also tests the quality of the assets recorded on the books. For example, if a company can generate $10 in sales with $5 of assets, then it is better than a comparable company in the same industry that needs $10 worth of assets to generate the same $10 in sales.

The single purpose of assets is to generate sales and ultimately profits. Therefore, companies with large fixed asset balances or goodwill should ultimately generate stronger revenues. A transaction should only be recorded as an asset if it has some future benefit. If not, then the transaction should be fully depreciated, amortized or in some cases written off completely.

Along those same lines, it is important to monitor sales in relation to receivables. The growth of a company's accounts receivable (A/R) should generally be in line, rather than above, its sales growth rates. If receivables are growing at a much faster clip than sales, then this could be a possible sign of trouble.

Sales should also be measured with respect to inventory. Ideally, a company should be increasing its inventory turnover ratio, thus converting inventory to cash at a faster rate. Finally, be sure to watch for a rising number of employees, which will sometimes show up in revenue per employee figures.

Finally, we come to capital structure, defined as Assets/Equity. The most important issue here is the number of shares outstanding. Is it rising, declining, or static? Be cautious of companies that employ toxic financing and have problems with shareholder dilution. A company with excess cash and few internal growth opportunities should return that money to shareholders in the form of dividends or share buybacks. A reduction in the outstanding share count will boost the Asset/Equity ratio. At the end of the day, a stock buyback will enhance per-share results and entitle all shareholders to a larger slice of the earnings pie. However, you should be cautious of share buybacks that are executed when the stock is overvalued, as this is a poor use of capital. You should also watch out for buybacks that merely cover up excessive management compensation practices funded with options.

With a closer examination of each of the components that drive ROE, investors will have a head start in determining which way this under-utilized metric is headed.

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In addition to providing educational guidance, in each issue of that newsletter editor John DiStanislao also delivers an in-depth look at a variety of deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing newsletter, as well as other guidance similar to this twice per month, you'll need to register for this separate publication. To learn more, please visit the following link:
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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In each issue of that newsletter, editors Nathan Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
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