Japanese automakers Toyota (NYSE:TM) and Honda (NYSE:HMC) are among the world's 100 biggest corporations, according to Forbes' May 2014 listing of the Global 2000 Leading Companies. Toyota occupies the No. 12 spot and Honda No. 70. In the last fiscal year ended March 2014, Toyota generated revenue of around $234 billion and earned profits of $17.9 billion, while for the same period Honda reported sales of more than $108 billion and earned $5.6 billion. In recent years, both companies have been big beneficiaries of the Japanese government's fiscal policies that included weakening the yen against major currencies of the world. Investors have huge expectations for both automakers, but which of the two generates more returns out of shareholders' money? Let's look for an answer.
The answer to our question lies in the two companies' return on equity, or ROE. While Toyota and Honda have raced neck-and-neck in this department over the last 10 years, Toyota recently has generated higher returns. In the last 12 months, Toyota delivered roughly 13% ROE compared with Honda's 10%. The world's largest automaker seems to be doing a better job with investors' funds than its smaller rival.
But looking at ROE in isolation can be tricky because it's a product of several factors. For example, a lower tax rate or a higher proportion of debt could push up ROE without any change in a company's ability to generate profits. To find out if Toyota's core profitability is indeed higher than Honda's, or whether other factors are at play, let's deconstruct the two auto giants' ROEs. In order to do that, we'll use the DuPont model, which computes ROE as a product of five ratios. The chart below shows the ratios and how the two companies have stacked up against each other in the last 12 months.
Which company generates superior returns?
Toyota and Honda have comparable interest burdens, tax efficiency, and equity multipliers, so we'll put them aside in this analysis, and focus on the EBIT margin and asset turnover. These two ratios tell an interesting story: Honda is using its assets more efficiently to generate sales, but Toyota is doing a better job in converting its sales into profit.
Toyota's asset turnover ratio has consistently remained in the range of 60% to 70% in recent years. Honda's asset turnover ratio has fluctuated in the last half-decade, but in the last two years it has remained close to the 80% mark.
In terms of profitability, Toyota has maintained a superior EBIT margin compared with Honda through much of the last decade, though Honda fared better during the financial crisis and in 2011 following the tsunami in Japan. In the past couple of years, Toyota has widened its lead over Honda in terms of margins, which in turn has translated into better returns on shareholders' equity.
Toyota is gaining from strength in its U.S. sales, offsetting the weakness in Japan and some emerging markets such as Thailand. The company has redesigned its Highlander and Lexus GX models to successfully capitalize on the solid demand for SUVs in the U.S. Toyota's profit for the quarter ended in June was 587.8 billion yen ($5.4 billion at current rates), much higher than the 497.3 billion yen ($4.57 billion) Bloomberg analysts expected. The first-quarter momentum has continued: U.S. deliveries have climbed 6% in the first eight months of 2014.
In its quarter ended in June, Honda reported a 7.1% increase in operating profit to 198.04 billion yen ($1.82 billion), ahead of the 181.8 billion yen ($1.67 billion) that Reuters analysts had predicted. Its operating margin of 6.6% was lower than Toyota's 10.8% in the same period. Honda's operating margin in the automotive business was even lower at 4.3%, burdened by start-up costs related to new factories in Mexico, Thailand, and Brazil. Honda has not cashed in on the recovery in the U.S. auto market as much as it would have liked. Deliveries are down 1% in 2014 through August as sales of popular models like the Odyssey minivan and Pilot crossover remain weak.
Honda's also struggling with its premium Acura brand. Luxury cars help margins and Acura's poor sales in recent years is weighing on Honda's profitability. In 2014, Acura sales are down 3% through August.
For the fiscal year ending March 31, 2015, Toyota has forecast operating income of 2.3 trillion yen on sales of 25.7 trillion yen, which translates into an operating margin of nearly 9%. For the same period, Honda is looking at an operating income of 0.77 trillion yen on sales of 12.8 trillion yen, which indicates an operating margin of 6%. Both forecasts are in line with margin trends seen in the recent past from the two companies.
Toyota is generating higher ROE than Honda on the back of its superior profit margin. Honda's margins in the automotive business need to improve before it can increase returns for its investors. However, both companies are big movers in the auto world and stand to gain from opportunities arising in the various markets they serve.
ICRA Online and Eshna Basu have no position in any stocks mentioned. The Motley Fool recommends BMW and Nike. The Motley Fool owns shares of Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.