QUESTIONS AND PRACTICE PROBLEMS
4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
Return on Equity ( ROE ) and the DuPont System
Return on equity (ROE) is one of the most commonly referenced ratios, and for good reason:
it measures the return earned by the equity holders on their investment in the company. It is calculated as the net income (NI) divided by shareholders ’ equity (SE), as shown in Equation 4-1 . 2
[4-1] ROE =NI
SE
Learning Objective 4.2 Explain why return on equity is a key financial ratio used to assess a firm ’ s performance.
return on equity (ROE) the return earned by equity holders on their investment in the company; net income divided by shareholders ’ equity
1 This is not because they make mistakes but because they employ different definitions of the same ratio.
2 ROE can also be defined as NI available to the common shareholders (i.e., NI − preferred dividends) divided by common equity (CE). For CP, there is no difference, because the company does not have any preferred equity. For some firms, it can make a difference.
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99 CHAPTER 4 4.2 A Framework for Financial Analysis
We will calculate the 2014 ROE for Canadian Pacific Railway Ltd. (CP), using the figures reported in the company ’ s financial statements, which were included in Chapter 3 . (We will also use CP ’ s figures to calculate the other ratios introduced in this chapter.) In 2014, NI was
$1,476 million, while SE was $5,610 million, so CP ’ s ROE was as follows:
ROE NI SE
1 476 5 610, 26 31
, . %
This is a healthy ROE figure that would be rated above average, which suggests that CP lies at the upper end of corporate profitability in Canada (or anywhere else for that matter).
ROE is not a “pure” financial ratio because it involves dividing an income statement (flow) item by a balance sheet (stock) item. 3 As a result, some people calculate the ROE as NI over the
“average” SE—that is, the average of the starting and ending SE. This adjustment acknowl- edges that NI is earned throughout the year, so it makes sense to divide by an average of SE to recognize that not all of those funds were invested throughout the year. For example, the end- ing SE is partly the result of the retained earnings for the year, which, in turn, is dependent on the net income for the year; however, with three years of data, the use of the average SE causes the loss of an observation. This is why most analysts use the ending SE as the denominator simply to get more estimates of the ROE; that way, they can assess a trend over time. However, this tends to understate a firm ’ s profitability on average, because the ending SE will usually exceed the average for the year if the firm is profitable.
The next step in financial analysis is to understand where CP ’ s ROE came from. The most popular approach to “decomposing” ROE is attributable to the DuPont Corporation, which pioneered a variation of the expansion of the ROE shown in Figure 4-1 .
ROE
×
×
GOOD OR BAD?
Leverage Ratio
NI Revenues
Revenues TA
Efficiency Ratio
Productivity Ratio ROA=NI
TA
TA
= SE
FIGURE 4-1 DuPont System
The DuPont system provides a good starting point for any financial analysis and is com- monly included in research reports as a way to summarize a firm ’ s key financial ratios. Many analyst reports, such as those provided by Morningstar Inc., provide a DuPont analysis as a way of summarizing a company ’ s financial performance. We will provide such an analysis below for CP, and you will see how all the reported figures and ratios are related as you pro- ceed through this section, with particular emphasis on the 2014 numbers for CP.
The DuPont approach defines the firm ’ s return on assets (ROA) as NI divided by total assets (TA), as shown in Equation 4-2 .
return on assets (ROA) net income divided by total assets
3 “Pure” ratios involve dividing an income statement item by another income statement item, or dividing a balance sheet item by another balance sheet item.
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100 CHAPTER 4 Financial Statement Analysis and Forecasting
[4-2 ] ROA NI
TA For CP in 2014,
ROA NI TA
1 476 16 640, 8 87
, . %
If the ROA is multiplied by TA and divided by SE, the TAs cancel out and produce the ROE.
So what is TA divided by SE? This is called the leverage ratio , and it measures how many dol- lars of total assets are supported by each dollar of SE, or how many times the firm has “lever- aged” the capital provided by the shareholders into total financing. It is shown in Equation 4-3 .
[4-3 ] Leverage TA
SE The 2014 leverage ratio for CP is as follows:
Leverage TA SE
16 640
5 610, 2 9661 296 61
, . . %
Thus, CP has leveraged every dollar of shareholders ’ equity into $2.97 of total financing by using debt and other forms of liabilities to help finance its operations.
We interpret the ROA as saying that every dollar of total assets earned a return of 8.87 per- cent, but the shareholders didn ’ t provide all this financing. They provided about 33.7 percent of the money to buy the firm ’ s total assets (i.e., 1/2.9661)—that is, the firm leveraged each dollar of shareholders ’ equity by 2.9661. As a result, the ROE is the ROA of 8.87 percent multi- plied by the leverage ratio of 2.9661, which gives an ROE of 26.31 percent. What this figure means is that part of the reason for CP ’ s high ROE is that it is extremely profitable and has a high ROA of 8.87 percent. The rest of the story is that CP magnified this ROA using financial leverage. This is why, when we analyze corporate performance, we look at ROE, ROA, and a series of ratios that measure financial leverage , since how the firm finances its operations is very important.
We can now decompose ROA into two of its major components: the firm ’ s net profit margin and its (asset) turnover ratio , which we show in Equation 4-4 and Equation 4-5 .
[4-4 ] Net profit margin NI Revenues
[4-5 ] Tu over ratio Revenues rn TA
Multiplying the two ratios together cancels the revenues figure on the bottom of net profit margin with the revenues figure on the top of the turnover ratio, leaving NI/TA, or, simply, the ROA, as shown in Equation 4-6 .
[4-6 ] ROA NI
TA
NI Revenues
Revenues TA
For CP, the 2014 net profit margin or (return on revenues) was as follows:
Net profit margin NI Revenues
1 476 6 620, 22 30
, . %
leverage ratio total assets divided by shareholders ’ equity; it measures how many dollars of total assets are supported by each dollar of shareholders ’ equity, or how many times the firm has leveraged the capital provided by the shareholders into total financing
financial leverage the use of capital provided by shareholders to increase total financing
net profit margin part of return on assets; net income divided by revenues
turnover ratio part of return on assets; revenues divided by total assets
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101 CHAPTER 4 4.2 A Framework for Financial Analysis
So CP made profits of over 22 percent of revenues earned. We look at the net profit margin to determine how efficiently the firm converts revenues into profits. Later in the chapter, we will expand our analysis to include additional efficiency ratios.
So if every dollar of revenue earned CP 22.3 percent in profits, how many dollars of revenue did it generate from each dollar invested in assets, or, alternatively, what was its turnover ratio?
Turnover ratio Revenues TA
6 620
16 640, 0 3978
, .
For 2014, with total assets of $16,640 million, CP generated revenues of $6,620 million. In other words, each dollar of assets generated about $0.3978 in revenues. The turnover ratio is a productivity ratio, as it measures how productive the firm is in generating revenues from its assets. As you will see, several productivity ratios can be calculated to determine the main drivers of this overall productivity.
Now we have the major ratios of the DuPont formula. Putting them all together produces Equation 4-7 . 4
ROE NI
SE
NI
TA
TA SE Revenues
Revenues
Net profit margin Turnoveer ratio Leverage ratio
[4-7 ]
For CP in 2014,
ROE NI SE
NI
TA TA SE Revenues
Revenues
0 223 0 3978 2 9661 26. . . ..31% (as calculated at the start of this section)
Each dollar of equity supported $2.9661of assets, which, in turn, generated $0.3978 in rev- enues, which, in turn, generated a net profit margin of 22.3 percent. In other words, overall, the ROE is determined by leverage, turnover, and profit margin. So what does this mean?
Interpreting Ratios
A single ratio on its own provides little information. To judge whether a given ratio is “good” or
“bad” requires some basis for comparison. Two bases are commonly used for comparison:
1. The company ’ s historical ratios, or the trend in its ratios
2. Comparable companies—for this purpose, we can use a similar company or use indus- try average ratios
Table 4-1 includes CP ’ s DuPont analysis ratios for 2012–14.
TABLE 4-1 Canadian Pacific ’ s DuPont Ratios
2014 2013 2012
ROE 0.2631 0.1233 0.095
ROA 0.0887 0.0513 0.0329
Net profit margin 0.223 0.1427 0.085
Turnover 0.3978 0.3595 0.3867
Leverage 2.9661 2.4038 2.8893
4 This is the simplest and most commonly used version of the DuPont system. There are other versions, which we do not discuss here, many of which break ROE into five or more components.
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102 CHAPTER 4 Financial Statement Analysis and Forecasting
Often, unique factors drive a particular firm ’ s ratios and make them difficult to compare with the ratios of other firms. For example, if a firm has made a recent large acquisition of another firm, key profitability and turnover ratios often drop. For this reason, it is important to look at a firm ’ s ratios over time. What we can observe from Table 4-1 is that CP was profitable in all three years, with ROEs ranging from 9.5 percent to 26.31 percent. We also observe a sig- nificant increase in profitability since 2012, which is the year that company management and the board of directors were transformed as a result of the successful proxy battle waged by Pershing Square (mentioned in Chapter 2 ). The net profit margin was the driving force behind this increase in ROE, increasing from 8.5 percent in 2012 to 22.3 percent in 2014. Both the turnover ratio and the leverage ratio increased only slightly over the three‐year period.
So how does CP compare with its competition? In order to make such a comparison we look for a similar company, and Canadian National Railway Company (CN) is a logical candi- date. CN is Canada ’ s only other major railway company. It is larger than CP, with 2014 year‐
end total assets of $31.8 billion (versus $16.6 billion for CP), 2014 revenues of $12.1 billion (versus $6.6 billion for CP), and a 2014 year‐end market capitalization of $64.8 billion (versus
$37.2 billion for CP). Aside from CN, it also makes sense to look for similar U.S. railways, and there are four logical candidates—Union Pacific Corporation (UNP), CSX Corporation (CSX), Norfolk Southern Corporation (NSC), and Burlington Northern Santa Fe (BNSF). These four firms account for approximately 90 percent of the U.S. industry market share. They are all larger than CP, but are reasonable comparators. For example, the total assets for UNP, CSX, NSC, and BNSF respectively are $24.0, $12.7, $11.6, and $22.7 billion (all in U.S. dollars). They also compare well to CP along several dimensions, such as product offerings and market presence. 5
Table 4-2 provides the DuPont ROE data for CN and the averages for the four U.S. firms, which we label “U.S. Industry,” for 2012–14. These ratios are comparable to CP ’ s ratios, and it should be noted that all six firms have a December 31 fiscal year end. 6
TABLE 4-2 Canadian National and U.S. Industry Average DuPont Ratios
Canadian National U.S. Industry Average
2014 2013 2012 2014 2013 2012
ROE 0.2351 0.2017 0.2432 0.1661 0.1604 0.1658
ROA 0.0996 0.0866 0.1005 0.0686 0.066 0.0636
Net profit margin 0.261 0.247 0.2702 0.1834 0.1807 0.1717
Turnover 0.3817 0.3506 0.3721 0.3713 0.3649 0.3701
Leverage 2.3602 2.3286 2.4196 2.406 2.4409 2.598
The ROE, ROA, net profit margin, and turnover ratio for CN are all similar to the 2014 fig- ures for CP, while the CN leverage ratio is lower. CN ’ s performance has been much more con- sistent over the three‐year period than CP ’ s, and it significantly outperformed CP in 2012 and 2013, but CP has improved. Both CP and CN outperformed the U.S. industry average in terms of ROE, ROA, and net profit margin, and the turnover ratios for the U.S. firms are similar to those of both CP and CN. The U.S. industry average leverage ratio is similar to that of CN, and so is below that of CP.
5 Also, recall that CP ’ s financial statements have been prepared in accordance with U.S. GAAP, and we want to compare “apples with apples” to the greatest extent possible.
6 The choice of fiscal year end can have a significant impact on reported financial ratios, based on annual financial statements, especially for firms that face a seasonal sales cycle. As a result, several balance sheet items, such as loans outstanding, accounts receivable, inventory, and accounts payable, will vary considerably during the year. The analyst must be aware of these factors when evaluating the ratios and also when comparing to other “similar” firms that choose different fiscal year ends.
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103 CHAPTER 4 4.3 Leverage Ratios
Overall, we could say that CP ’ s profitability has improved significantly and is currently similar to that of CN and superior to that of the U.S. railroads. CP also displays average asset turnover and is slightly more highly levered. However, we should consider any possible con- tributing factors before reaching final conclusions. To get a better understanding of these results, we will extend the analysis of the leverage, efficiency, and productivity ratios.
1. What three areas of a fi rm ’ s operations does the DuPont system provide information about?
2. All else being equal, list three factors that will lead to higher ROE ratios.
3. What can we use as a basis for comparison when looking at fi nancial ratios? What kind of information can we gain from this comparison?
CONCEPT REVIEW QUESTIONS