As another article in this series explained, high profit margins can make a business look attractive. With profit margins such a critical part of return on equity, such a company should have a substantial edge, right?
Perhaps not. Although profit margins are crucial, sales generated for each dollar of assets plays an equally important role. Many high profit margin businesses don't produce strong sales from the assets they've invested. Generating more sales on fewer assets means tying up less capital the business generates in fixed assets. The term "capital-intensive" refers to the way some businesses require more capital than others to function. If a company needs substantial assets to generate high profit margins, its capital-intensive nature will often reduce its return on equity.
Asset management is probably one of the factors individual investors have the most difficulty using to evaluate a company. Certainly you can compare various asset management ratios for companies within an industry. But how can you tell if a certain amount in sales per dollar of total assets is good or not good for a given company on more than just a relative basis?
Looking at asset management in the context of the total return on equity allows an investor to balance a company's asset management ability with its profit margins and the financial leverage it uses to discern whether the business is, in fact, great or whether it's simply mediocre.
Because capital-intensive businesses have to use and maintain billions in assets, even ones with high profit margins aren't necessarily as exciting as they might be for an investor. And those businesses constantly have to invest new capital to generate revenues, so they can't return as much cash generated from operations to investors.
Conversely, a company that ramps up its asset management policies can improve shareholder return without necessarily raising its profit margins. For instance, one substantial investment that many companies make is in inventory. If a business can manage its inventory more efficiently, it can increase its return on equity. Minimizing inventory reduces total assets employed, leading to more sales per dollar of assets and leaving more cash on the balance sheet to distribute to shareholders or use for other projects.
The same holds true for low profit margin businesses as well. Often, such companies trade at low multiples because of the perception that they are commodity businesses with little opportunity for growth. However, if a business can structure its operations so that it has relatively small inventories on hand that it constantly sells and replenishes from production, then it will require fewer assets to generate a dollar of sales. A common tactic in recent years is to divert the resulting cash to stock buybacks, especially when the company is seen as undervalued.
As you can see, improved asset management can increase shareholder return. Better asset management eventually shows up in the form of high profit margins, but high profit margins by themselves do not guarantee that shareholders will receive excellent returns.
To ensure that return on equity is high, investors must look for businesses that have high margins and high asset turnover rates, whether it is sales to assets, looking at the inventory turns, the days sales outstanding (or collection period), the payables period, or the turnover in fixed assets. The last variable in the return-on-equity equation that can affect overall return is financial leverage.
For more lessons on return on equity, follow the links at the bottom of our introductory article.