ROE and related ratios or how to understand the strategy of a company

One of the most popular ratio in financial analysis is the Return on Equity (RoE).

The Return on Equity ratio is calculated as below :

RoE = Net income / Average Shareholders Equity

Let's have some examples with Apple, Microsoft and Amazon :

- RoE of Apple : 57 411 / ((65 339 + 90 488)/2) = 73,69%

- RoE of Microsoft : 44 281 / ((118 304 +102 330)/2) = 40,14%

- RoE of Amazon : 21 331 / ((93 404+62 060)/2) = 27,44%

 

And now the RoE ratio is composed of several other ratios :

RoE = RoA (Net Income / Average on Assets) x Financial leverage (Average Assets / Average Equity)

And the RoA or Return on Assets, is composed as below :

RoA = Return on sales (Net income / Sales) x Assets turnover (Sales / Average assets)

Then the RoE and related ratios depend on the formula below :

RoE = Return on sales (Net income / Sales) x Assets turnover (Sales / Average assets) x Financial leverage (Average Assets / Average Equity)

 

Let's take again our three companies - Apple, Microsoft and Amazon - and calculate the different ratios which, put together, give the RoE. What are the lessons that you can get from those ratios to have a better financial analysis ?

Apple :

RoE : Return of sales (1) x Assets turnover (2) x Financial leverage (3)

(1) Return of sales : (57 411/ 274 150) = 20,94%

(2) Assets turnover : 274 150 / ((323 888+338 516)/2) = 82,77%

(3) Financial leverage : ((323 888 + 338 516)/2) / ((65 339 + 90 488)/2) = 4,25

As you can remember the RoE which was at a very high level - 73,69% - can be explain overall by the financial leverage of 4,25 that is quite high. This is due to the large amount of shares buy back that has reduced the amount of the shareholders equity. The shares buy back has highly increased the financial leverage of Apple. Meanwhile, the return of sales is also at a very high level with a net margin for the company at 20,94%. And the asset turnover is also impressive that is to say you don't need a large amount of assets to deliver as much as 274 B$ of sales. 

All things together, those three ratios explain how is construct the RoE ratio and his high level of 73,69%

Microsoft :

RoE : Return of sales (1) x Assets turnover (2) x Financial leverage (3)

(1) Return of sales : (44 281/ 143 015) = 30,96%

(2) Assets turnover : 143 015 / ((301 311+286 556)/2) = 48,65%

(3) Financial leverage : ((301 311+286 556)/2) / ((118 304 +102 330)/2) = 2,66

 Microsoft has a lower RoE than Apple, around 40,14%. This can be explained by two major factors :

- Microsoft is less financially leveraged than Apple

- Microsoft has assets turnover that is lower than Apple. That is to say, Microsoft needs as much as twice more asset than Apple to make a sale of 1$. To understand why, we need to dive more into the business model of Apple and Microsoft. But I think if we breakdown the sales of Apple https://www.investopedia.com/apple-s-5-most-profitable-lines-of-business-4684130 ) we can see that they have a business line called Services that generates a gross margin, around 63% - that's pretty huge !! - and for that business line they don't need a lot of assets.

Meanwhile, we can see that Microsoft has the highest net margin with a 30,96% return of sales. To be more precise, they earn 30$ after taxes for every 100$ of sales.

Amazon :

RoE : Return of sales (1) x Assets turnover (2) x Financial leverage (3)

(1) Return of sales : (21 331/ 386 064) = 5,52%

(2) Assets turnover : 386 064 / ((321 195+225 248)/2) = 141,3%

(3) Financial leverage : ((321 195+225 248)/2) / ((93 404+62 060)/2) = 3,5

We can immediately notice that the net margin of Amazon is very low compared to Apple and Microsoft. Because, they don't have the same strategy. Amazon prefers to have large volume of sales but a lower margin (as many retailers like Walmart....), when Apple prefers to sell premium products with very high margins. 

Meanwhile, Amazon has the highest asset turnover among the three companies. Again, the strategy of Amazon is to make a lot of volume to lower the price and have competitive advantage against the others retailers.

(If you are interested Tesla has the same strategy to compete against car manufacturers : https://investisseur-intelligent.fr/blogs/sebastien-campredons-blog/business-model-point-commun-entre-tesla-et-amazon-apple).

 

 

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The opinions and content shared in this blog are for informational and educational purposes only and should not be interpreted as a recommendation to buy, sell or any other type of investment transaction, or request for transactions or clients.

Past performance of exposed strategies or assets may not continue or be inconsistent, and stocks or bonds, or crypto assets may not behave as described.

The information in this blog is believed to be adequate, but no one should act on the information it contains. It is not recommended that anyone act on any investment information without first consulting an investment adviser as to the suitability of such investments for their personal circumstances.

 

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