The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
--Warren Buffett in his 1979 letter to shareholders
Warren Buffett has long said that the best businesses to own are those that consistently generate above-average returns on equity, or ROE. For more on his thoughts, see his letters to shareholders from 1977, 1979, 1987, 1992, and 2009, among others.
Companies that generate high returns on equity are typically not capital intensive so they generate cash rather than burning through it. These businesses also often have a moat protecting their profits from the competition. Because they can generate increasing amounts of earnings power (and free cash flow) with limited reinvestment needs, high ROE businesses have the ability to increase in value over time. Shares of these companies have historically outperformed the market because the stock prices eventually appreciate to trade in line with the company's growing intrinsic value.
Finding companies that generate above-average returns on equity is a first step. But to understand why they are generating higher returns than the industry, we need to understand the drivers of ROE, and that is where the DuPont Analysis comes in hand. The DuPont method breaks down ROE into its component parts, helping investors understand if returns are driven by (1) high profit margins, (2) high asset turnover, (3) high debt, or some combination of the three.
I will now use the DuPont method to compare the returns on equity at The TJX Companies (TJX +0.25%) and Ross Stores (ROST +0.25%), two off-price retailers that sell brand-name goods at 20% to 60% less than the competition. All of my numbers come from The TJX Companies 2013 annual report and Ross Stores 2013 annual report, found at their respective websites. Calculating ROE using the DuPont method should give you the exact same number (down to the decimal) you would get calculating ROE using the traditional method (net income/shareholder equity).
The rest of this article has a lot of numbers, but the math is not complicated, and the work will pay off. All you have to do is follow the steps below. Here we go!
TJX Companies
Net operating assets = total assets – (total liabilities – debt)
Net operating assets = 10,201,022 – (5,971,129 – 1,274,216)
Net operating assets = 5,504,109
Operating asset turnover = sales/net operating assets
Operating asset turnover = 27,422,696/5,504,109
Operating asset turnover = 4.982223
Gross profit margin = (sales – cost of goods sold)/sales
Gross profit margin = (27,422,696 – 19,605,037)/27,422,696
Gross profit margin = .28508
SG&A expense margin = SG&A/sales
SG&A expense margin = 4,467,089/27,422,696
SG&A expense margin = .162898
Tax expense margin = (provision for income taxes + (tax rate x interest expense))/sales
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Tax rate = provision for income taxes/income before taxes
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Tax rate = 1,182,093/3,319,489
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Tax rate = .356107
Tax expense margin = (1,182,093 + (.356107 x 31,081))/27,422,696
Tax expense margin = .04351
Operating expense margin = SG&A expense margin + tax expense margin
Operating expense margin = .162898 + .04351
Operating expense margin = .206408
Operating profit margin = gross profit margin – operating expense margin
Operating profit margin = .28508-.206408
Operating profit margin = .078672
Return on net operating assets (RNOA) = operating profit margin x operating asset turnover
Return on net operating assets = .078672 x 4.982223
Return on net operating assets = .391963
Debt/Equity = 1,274,216/4,229,893
Debt/Equity = .301241
Cost of debt = (interest expense x (1 – tax rate))/Debt
Cost of debt = (31,081 x (1-.356107))/1,274,216
Cost of debt = .015706
Financing spread = RNOA – cost of debt
Financing spread = .391963-.015706
Financing spread = .376257
Return on debt = Debt/Equity x financing spread
Return on debt = .301241 x .376257
Return on debt = .113344
ROE DuPont Method = RNOA + return on debt
ROE DuPont Method = .391963 + .113344
ROE DuPont Method = .505307
ROE DuPont Alternative = (net income/sales) x (sales/assets) x (assets/equity)
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This is the same thing as saying ROE = (profit margins) x (asset turnover) x (leverage ratio)
ROE DuPont Alternative = (2,137,396/27,422,696) x (27,422,696/10,201,022) x (10,201,022/4,229,893)
ROE DuPont Alternative = .505307
ROE Traditional Method = net income/shareholder equity
ROE Traditional Method = 2,137,396/4,229,893
ROE Traditional Method = .505307
Ross Stores
Net operating assets = 3,896,797 – (1,889,495 – 150,000)
Net operating assets = 2,157,302
Operating asset turnover = 10,230,353/2,157,302
Operating asset turnover = 4.742198
Gross profit margin = (10,230,353 – 7,360,924)/10,230,353
Gross profit margin = .280482
SG&A expense margin = 1,526,366/10,230,353
SG&A expense margin = .1492
Tax rate = 506,006/1,343,310
Tax rate = .376686
Tax expense margin = (506,006 + (.376686 x -247))/10,230,353
Tax expense margin = .049452
Operating expense margin = .1492 + .049452
Operating expense margin = .198652
Operating profit margin = .280482-.198652
Operating profit margin = .08183
RNOA = .08183 x 4.742198
RNOA = .388054
Debt/Equity = 150,000/2,007,302
Debt/Equity = .074727
Cost of debt = (-247 x (1-.376686))/150,000
Cost of debt = -.00103
Financing spread = .388054 – (-.00103)
Financing spread = .389081
Return on debt = .074727 x .389081
Return on debt = .029075
ROE DuPont Method = .388054 + .029075
ROE DuPont Method = .417129
ROE DuPont Alternative = (837,304/10,230,353) x (10,230,353/3,896,797) x (3,896,797/2,007,302)
ROE DuPont Alternative = .417129
ROE Traditional Method = 837,304/2,007,302
ROE Traditional Method = .417129
The above analysis shows that The TJX Companies generated ROE of about 51% and Ross Stores generated ROE of about 42% in 2013. Interestingly, they had very similar operating margins (of around 8%) and asset turnover (of around 5x). But The TJX Companies had meaningfully higher ROE because of its use of debt to boost returns. The TJX Companies debt/equity ratio was 30% and its return on debt was about 11% compared to Ross Stores debt/equity ratio of about 7.5% and a return on debt of only about 3%. TJX's 8% higher return on debt explains almost all of the 9 percentage point difference in ROE between the two companies.
Finally, although TJX is boosting returns with leverage, it maintains a rock-solid balance sheet. As of its 2013 annual report, it had about $875 million more in cash than debt and its interest coverage ratio (defined as EBIT/interest expense) was a very healthy 59x ($3,350,570/57,084). Note, if I would have used the interest expense line item on the income statement ($31,081) which is net of capitalized interest and interest income, the ratio would jump to 108 times. The interest coverage ratio measures how many times a company's operating income (EBIT) can cover its annual interest expense (or how easily it can service its debt) and is an important measure of a company's financial health.
Fool on!
