When we talk about financial companies at the Motley Fool, we often talk about return on equity (ROE), a widely used measure of profitability that Rule Makers such as American Express (NYSE: AXP) keep tabs on.

The company, which makes those prestigious green cards, tracks ROE on a quarterly basis, breaks out the number in its earnings releases, and established a corporate-wide goal of maintaining a 20% ROE. It has beaten this mark easily over at least the last three years, reporting ROE of 25.5% in Q2, up from 25.3% a year ago.

In fact, American Express senior managers have bonuses and incentive payouts based on ROE, revenue growth, net income, and shareholder return, according to a recent UBS Warburg research report.

Why is ROE important?

For starters, it's a basic measure of profitability. The formula is pretty simple: net income divided by average shareholders' equity. This ratio tries to capture net earnings relative to the amount of money shareholders have invested. We want to know what we're getting for our money, right?

This is a good start, but to understand ROE you need to understand the concept of shareholders' equity. What is it? Simple. It's what's left over when you subtract total liabilities from total assets. Shareholders' equity, therefore, represents shareholders' claims on a company's assets -- everything else is owned by creditors.

I looked at American Express' ROE for calendar year 1999 and 1997 and came up with slightly different numbers than the company:

ROE               1999      1997
My numbers        25%       21.9%
AMEX Numbers      25.3%     23.5%
Aside from the differences in our respective calculations, this is very impressive growth in a three-year time span, especially considering that most companies struggle to hit even 15% ROE.

Still, the work is less than half done at this point. We need to know what's driving ROE higher, since higher leverage in good times can boost profitability. Besides, just knowing American Express has a 25% ROE doesn't tell us anything about the business.

Investors should be familiar with the DuPont ROE equation, which tells us the components of ROE.

ROE = Net Margin x Asset Turnover x Leverage

Here are the component formulas:

ROE = (Net Income/Sales) x (Sales/Average Total Assets) x (Average Total Assets/Average Equity)

Your eyes may glaze over at the sight of these formulas, but seeing how ROE breaks down has really helped me understand its business importance. I've found that crunching numbers is one thing, but understanding what they mean and how they apply to a given company is another. Let's take a quick look at each component.

Rule Maker readers are pretty familiar with net margins, so I won't go into that. (Here's a link for anyone interested.) Asset turnover measures how well a firm manages its assets. Companies have assets to generate revenues, right? One way to measure success in this department is to see how many times per year a dollar of assets generates a dollar of sales.

The leverage ratio measures debt. Since the leverage ratio measures equity relative to total assets, we like to see the numbers low and getting lower. Here's what I found for American Express in all three areas:
                   1999      1997 
Net Margin        12.7%     11.21%
Asset Turnover    14.14%    15.54%
Leverage          13.91%    12.62%
Looking at the three-year trend, we see American Express boosted its ROE by increasing net margins and employing higher leverage. In my book, higher leverage isn't something to cheer about, though if effectively managed it can be a useful tool. Lower asset turnover isn't what we want to see either, even though the company's turnover ratios have historically been better than the industry average.

Nevertheless, higher net margins are the only thing that looks better in this equation over the last three years, from my point of view. The improvement, however, is substantial. That 1.5 percentage point increase in the net margin added $291 million to American Express' bottom line -- which represents 12% of the company's 1999 net income.

How did it do this? The company has been able to increase margins because discount revenues are higher, and because members are spending more on their cards. Discount revenue is the cut American Express earns from merchants on card purchases. This account increased to $6.7 billion in 1999 from $5.7 billion in 1997. Average basic card member spending also increased, jumping to $7,758 from $6,473 over the same period.

In addition, the company's total loans outstanding, which represents receivables on its credit card products, increased to $23.4 billion in 1999 from $14.6 billion in 1997. In this case, it's a healthy trend to see receivables growing, since the company earns interest on those accounts. As long as it appropriately increases loss reserves and remains prudent about issuing cards and managing accounts, this is the kind of growth we want to see.

So, there you have it. American Express increased ROE by increasing net margins and slightly increasing its leverage. While I have somewhat mixed thoughts on these results, I'm pleased overall.

What do you think? Should Rule Maker investors pay attention to profitability measures like ROE, or do we have that covered by screening for companies with high margins, efficient asset management, and strong cash flow? Post your thoughts on the Rule Maker Strategy discussion board.

Related Links:

  • A Stroll Through the AMEX Annual Report
  • A Rule Maker Evaluation of American Express
  • Rule Maker to Buy AXP

    Have a great day.