Earning a high return on equity is one of the primary reasons to do business. Managers of (and investors in) companies want to earn the highest return on their equity as possible, and sustain this high rate of return over as long a period as possible. Some sectors of the market, like consumer staples, have had remarkably high returns over the very long-term, while others, like automobiles, have had extremely cyclically returns on equity.
The market as a whole is cyclical too, sitting somewhere between these two extremes over the past fifty years. In this piece I’ll break the market-level return on equity into its components (profit margin, asset turnover, and financial leverage) and try to identify where we are in the current cycle.
High return on equity is almost always a good thing, but the source of return can come from three different areas.
1. Profit Margin—calculated as net income (earnings) divided by sales (revenue), this simple measure shows how much of a company’s (or the market’s) sales are converted to bottom line earnings after all ordinary or extraordinary expenses. Higher margin = higher return on equity.
2. Asset Turnover—calculated as sales divided by average assets, this measure shows how “productive” assets are. Imagine two companies that both use similar machines (which each cost $10,000) to make widgets. Company A uses its machine to produce $10,000 in widget sales per year while company B uses its machine to produce $20,000 in sales. Company A has an asset turnover of 1.0 while company B has an asset turnover of 2.0. Company B is using its assets more effectively. Higher asset turnover = higher return on equity.
3. Financial Leverage—calculated as average total assets divided by total common (owner’s) equity, this measures how much the company has borrowed to earn its way. Leverage is always a tricky beast. Some leverage often makes sense and is an easy way to boost returns and profits; but too much leverage can spell doom. Higher financial leverage = higher return on equity.
With these three components, we can calculate return on equity as:
Profit margin * asset turnover * financial leverage = ROE
So where do we stand on these three measures? The figure below shows the rolling history of each—alongside the market’s total return on equity[i].
Several interesting trends emerge. While the market’s ROE itself has been very cyclical and mean reverting, the components have had more secular trends. Asset turnover has been in steady decline for several decades, falling from 1.23x in 1981 to 0.81x today. Financial leverage has also had a fairly steady decline from its all-time high of 3.4x in 1994 to 2.7x today. In fact, if you just multiply asset turnover times financial leverage, the resulting trend line looks very different from ROE.
That means that profit margins are the driving force (mathematically anyway) behind the market ROE’s cyclicality. Net profit margins can, in turn, be broken down into components just like ROE, and again there are three key variables:
1. Operating Margin—operating profits (earnings before interest and taxes) divided by sales
2. Interest Factor[ii]—Earnings after interest divided by operating earnings
3. Tax Factor[iii]— Net income divided by Pretax income (earnings after interest)
Just like with ROE, net margin is calculated as:
Operating margin * interest burden * tax burden = net margin
Here is the history of each component:
The two most recent spikes down in margin (and therefore in market-wide ROE) are due in large part to spikes down in the tax and interest factors. Think about interest, for example. During these two rough markets in 2000-2002 and 2007-2009, earnings fell off a cliff but fixed payments on interest remain fairly steady, so a much higher percentage of earnings are going towards interest payments.
Here is the combined effect of taxes and interest over time.
I am no good at predicting anything, but it’s clear that each of these components can have a large influence on the return the overall market’s ROE. While the combination of asset turnover and financial leverage appear to be in the midst of a secular decline, margins are near all-time highs. Can margins stay here much longer? Operating margins have moved off of their recent all-time high, while the combination of taxes and interest is reducing operating profits by less than is typical throughout history (meaning that the combination of low effective tax rates and cheap debt are allowing companies to “keep” more of their operating profits).
Interest rates will rise at some point (right?) and operating margins have been fairly cyclical in the past. My guess is that, like most things in the market, things will be cyclical and ROEs will decline. Hopefully this causes everyone to freak out so that we can buy stocks at cheaper multiples than we can today.
NOTE: I’d love to hear your thoughts on this piece. I am swimming in new macro/top-down waters here, because my investment philosophy/process is purely bottom up and ROE is not an important component in stock selection. I mainly write to learn, so these posts are me reporting data and learning on the fly, so I may be getting aspects wrong. Email me Patrick.firstname.lastname@example.org with any thoughts.
Calculation Note: Prior to 1976 I have to use annual data (as opposed to quarterly) due to availability issues.
[i] This entire analysis excludes financial stocks, where return on assets are often a better measure of returns. If people are interested I may do another post specifically on financials because they are such a large part of the market.
[ii] Normally these are called interest “burden” and tax “burden,” but I hate that name because a higher “burden” sounds bad but you want these numbers to be higher (because a higher number keeps the total margin higher).
[iii] Other items sit between Pretax income and net income and would be bundled in this calculation: noncontrolling interest income, extraordinary items, and discontinued operations