THE DRIVERS OF A HIGH RETURN ON EQUITY
As investors, we all want a high return on our money. Owning companies that consistently earn a high return on equity (ROE) is a good way to achieve high returns. Long-term investors have been following that strategy for many decades.
Over a hundred years ago, the Dupont Corporation developed a formula for analyzing and managing the drivers of return on equity.
ROE=Profit Margin×Asset Turnover×Financial Leverage.
Many new investors focus on a company’s profit margin, and that is a potent driver of ROE, but the other two factors, often overlooked, are just as important.
For example, grocery stores are well known to operate on slim profit margins and yet their massive sales revenue throughput often drives a robust ROE. At the other end of the spectrum, asset intensive companies like utilities and REITs often struggle to achieve a high ROE despite their impressive profit margins on revenue.
The companies in the table below are ranked from highest to lowest profit margin on revenue. The final column shows that a high profit margin is neither a necessary nor a sufficient condition to guarantee a high ROE.
| Company | Profit / Sales | Sales / Assets | Assets / Equity | ROE | |||
| VISA Inc. | 56.1% | x | 0.43 | x | 2.50 | = | 60% |
| RioCan Real Estate Investment Trust | 37.4% | x | 0.09 | x | 2.10 | = | 7% |
| Royal Bank of Canada | 30.9% | x | 0.03 | x | 18.20 | = | 16% |
| Melcor Developments Ltd. | 27.3% | x | 0.20 | x | 1.62 | = | 9% |
| Canadian National Railway | 27.2% | x | 0.29 | x | 2.80 | = | 22% |
| Apple Inc. | 26.2% | x | 1.17 | x | 4.97 | = | 153% |
| Restaurant Brands International | 17.9% | x | 0.37 | x | 4.97 | = | 33% |
| Dollarama | 17.7% | x | 0.92 | x | 6.01 | = | 98% |
| Shopify Inc. | 16.9% | x | 0.71 | x | 1.20 | = | 14% |
| Cameco Corporation | 16.4% | x | 0.36 | x | 1.44 | = | 8% |
| Constellation Software ) | 15.4% | x | 0.73 | x | 3.74 | = | 42% |
| American Express | 14.8% | x | 0.31 | x | 8.10 | = | 37% |
| Fortis Inc. | 14.3% | x | 0.16 | x | 3.30 | = | 8% |
| lululemon athletica inc. | 13.0% | x | 1.31 | x | 1.77 | = | 30% |
| Toll Brothers | 12.3% | x | 0.76 | x | 1.76 | = | 16% |
| Berkshire Hathaway | 12.0% | x | 0.30 | x | 1.87 | = | 7% |
| Enbridge Inc. | 9.4% | x | 0.30 | x | 3.92 | = | 11% |
| Genesis Land Development | 9.1% | x | 0.60 | x | 2.08 | = | 11% |
| Stantec Inc. | 7.5% | x | 1.19 | x | 2.06 | = | 18% |
| WSP Global Inc. | 7.2% | x | 0.72 | x | 2.54 | = | 13% |
| Linamar Corporation | 6.1% | x | 0.92 | x | 1.83 | = | 10% |
| Andrew Peller Limited | 5.1% | x | 0.73 | x | 2.09 | = | 8% |
| Metro Inc. (MRU, Toronto) | 4.7% | x | 1.49 | x | 2.12 | = | 15% |
| TFI International | 4.7% | x | 1.13 | x | 2.70 | = | 14% |
| Canadian Tire | 4.6% | x | 0.76 | x | 3.68 | = | 13% |
| Alimentation Couche-Tard | 3.5% | x | 1.78 | x | 2.56 | = | 16% |
| Costco | 2.9% | x | 3.57 | x | 2.64 | = | 27% |
The “worst” performer in terms of profit as a percent of revenue is Costco at just 2.9%, and yes, that does include the revenue from membership fees. However, Costco is highly profitable in terms of return on shareholder equity at 27%. Costco is an “asset light” operation. Each dollar of assets drives $3.57 in revenue which is, by far, the highest ratio among these companies. And each dollar of owners’ equity supports $2.64 of assets. This leverages its very modest profit margin on revenue percentage up to an extremely attractive ROE of 27%.
Similarly, Metro has a high throughput of $1.49 in sales revenue per $1.00 of assets. When combined with its debt leverage, Metro achieves a 15% ROE despite a low 4.7% bottom line profit margin. Grocery stores have mostly enjoyed a “free pass” when it comes to consumer blame for high food prices because it’s well known that grocery profit margins are slim. It’s less well known that their ROEs are quite attractive and lucrative.
Let’s next consider RioCan REIT, the second most asset-intensive company in the table. It makes 37.4 cents in profit for each dollar of revenue. That appears to be extremely attractive, but each dollar of its assets drives only 9 cents of revenue. That, combined with modest debt leverage, results in an ROE of only 7%.
Royal Bank is the most asset-intensive company on the list with only about 3 cents of revenue per dollar of assets. But, as is typical of banks, its equity is massively leveraged, with each dollar of equity supporting $18.20 of assets. Its 31% profit margin on revenue translates into a lucrative 16% ROE due to its extreme financial leverage, despite being extremely asset intensive.
Dupont’s century-old formula has stood the test of time. Seasoned investors know not to be blinded by flashy profit margins, and to equally value all the drivers that compose a corporation’s return on equity.