### Fundamental analysis: How to analyze and find profitable companies

In the last article we talked about the book value. In this article we are going to talk about profitability ratios of ROE and ROCE.

ROE or Return on Equity is calculated as Net Income/Average Shareholders Equity. ROE ratio helps in understanding the company’s earnings performance. It is a measure of Company’s profitability. ROE ratio has to be compared with peers, industry etc to get a better overall perspective. Consistent ROE greater than 15% is considered good.

Like with all other valuation metrics this one too suffers from the drawback if used in isolation. High debt on the books of the company and aggressive share buy backs can lower the equity base. A lower denominator means higher ROE .This is where analysis can go wrong. To make more sense of ROE we will have to study the Dupont Analysis.

THE DUPONT FORMULA TO CALCULATE ROE

As pointed out earlier there are various ways which can be used by the management to increase ROE without any corresponding increase in the earnings of the company. To get meaningful result from ROE we will use the DUPONT formula. The dupont formula breaks ROE into three parts.According to Dupont formula ROE is calculated as

ROE = Net Profit / Sales * Sales / Total Assets * Total Assets / Shareholder’s Equity

The three parts of the formula breaks down ROE into its key drivers

1. Net Profit Margin(Net Profit / Sales)
2. Return on Assets(Sales / Total Assets)
3. Equity Multiplier (Total Assets / Shareholders Equity)

Net profit margins show how efficient the company is in generating profits on each dollar of sale. A higher net profit margin and increasing trend shows that the company has pricing power and a competitive edge among its peers.

Asset turnover depicts how much sales a company is able to do from each dollar of asset. Generating good sales on limited assets suggest that the company is using its assets efficiently and it does not need to purchase new assets in order to boost its sales.

The Equity multiplier shows if the company is using excessive leverage to boost company’s ROE. If company has a huge debt and using increasing debt to survive then it’s a sure sign that it may collapse due to credit default.

ROE is a good performance indicator but it does not tell you everything about the company in order to overcome this problem we have to use it along with other metrics.

Usually we use another profitability indicator called ROCE. It is calculated as

ROCE = EBIT / Capital Employed

EBIT stands for Earnings before Interest and Tax

Capital Employed = Avg Debt Liabilities + Avg Shareholders Equity

Now the next question you would be asking is how these two ratios can help in finding profitable companies. To arrive at this answer we need to look at the below mentioned Illustration about two hypothetical companies. Company A and Company B

Company A

ROE ROCE

2011 19% 18%

2012 20.5% 19%

2013 17% 15%

2014 21% 20%

2015 23% 21%

Company B

ROE ROCE

2011 15% 8%

2012 16% 7%

2013 18% 9%

2014 19% 7.5%

2015 20% 8%

In the example above Company A has complementary ROE and ROCE. It has healthy debt on its books. On the other hand Company B has low ROCE which is an indicator of high debt.

It is safe to conclude that Company A would be better investment and yield better result. Company B should reduce their debt level to increase ROCE ratio. Its definitely putting stress on the company’s balance sheet.

Once we have shortlisted companies with complementary ROE and ROCE levels. We need to compare it with its book value & PE ratios. If they are available at lower end then there is a case for investment into these companies.

In the next article we are going to talk about PE ratios, its other variants and significance in investment. Stay tuned.