Saturday, July 07, 2007

Return on Equity, Episode III (ROE-EP3): Du Pont Decomposition

Return on Equity can be broken down into three different parts. This famous decomposition is known as the Du Pont Decomposition. Does it have to do with the chemical giant Du Pont? Probably yes, but for those interested, you can go Google and Wiki it up, now we are at the climax of the trilogy, so let’s move on. Recall that:

ROE = Net Profit / Shareholders’ Equity

This can be broken down into

ROE = Net Profit / Sales x Sales / Asset x Asset / Equity

Mathematically, this makes no sense as Sales and Asset are all cancelled out, why include them in the first place? Engineers cannot understand this. But when we break down ROE into these three elements, ROE can be re-written as

ROE = Net margin x Asset Turnover x Leverage

There are still a few twists and turns to the climax of this trilogy but to cut the story short it simply means that ROE is impacted by these 3 things

1) Net margin (which is Net Profit / Sales)
2) Asset Turnover (which is Sales / Assets)
3) Leverage (which is Asset / Equity)

In order to increase the company’s ROE, we just need to improve either one of the 3 things mentioned above.

We can reduce cost, hence even if sales remains the same, net margin goes up, ROE goes up. We can increase asset turnover, i.e. by making our existing asset work harder to generate more sales. Or we can increase debt.

Now (1) and (3) are easy. For (1) you just fire a whole bunch of people, make the rest work harder, or hire 10,000 cheap workers from emerging countries to replace those you fired. For (3), it is even easier, just borrow more. By borrowing, you increase the liabilities that your co incurs thereby increasing your asset base (usually as an increase in cash) which can translate into more sales and profits if those cash or assets are used correctly and hence ROE goes up.

To improve ROE by improving (2) i.e. increasing Asset Turnover is one hell of a job. I have got a post on that. Read this! Basically, when you see a company with high ROE, it pays to see how this high ROE came about. If it is due to high debt, then maybe it’s a Decepticon! So beware, there is more than meets the eye!

If it is due to either (1) or (2) then, probably it’s still ok. But if you see a company’s ROE improve over the years and it’s due to only (2), increase in Asset Turnover, then give the management some respect. It’s a job well done! And it is time to load the truck with stocks of this company!


  1. Hi there!
    Just got to your blog, very interesting read indeed! Kudos to you.
    But it seemed to me that value investors like yourself has come to a point of belittling shorter-term investors like myself.
    Value-investing seems overrated to me, made good by a certain buffet...
    He started out with very little like most of us and made good.
    But really, in this era, nobody wants to be like him to wait so long to finally see his fruit ripe.
    Have you guys forgotten the "velocity" part of money?

  2. Hi Anonymous,

    While a lot of my posts may sound offensive to ST investors, and perhaps subconsciously there may be some bias against ST investors, I would like to maintain that I believe in the freedom in choice of investment philosophy.

    If you can make money by playing Greater Fool Games (i.e. buying something that is overpriced in the hope of selling it to a Greater Fool), and you feel great about it, I have no qualms against that. In fact, a lot of pple made a lot of money that way. Who is to say that they are wrong?

    Value investors try to allocate capital efficiently so that good businesses get more money and bad businesses should shut down. That's like the nice nice idealogy that value investors subscribe to, but ultimately, we just want our money to make more money, like ST investors.

    But I think value investing requires a lot less effort and yet higher chance of not seeing -ve returns if practised correctly. That's the beauty of it. You need not watch live stock prices all day. Just do research, buy the stock and forget about it. 10yrs later, come back and reap the rewards...

    Also, contrary to what you say, I think value investing has never been overrated and probably never will be. If it did, then all capital should be allocated efficiently and everyone will get the same return as market return. Yet value investing still continues to outperform market return precisely bcos most pple simply invest based on emotions and hence value can be found when the crowds go crazy.

    So in a way, by promoting value investing, I am doomed to earn market return if everyone indeed starts to practise value investing. But that's fine bcos I believe in sharing the good things in life. Hehe!

  3. Yup, the one(s) who achieve their projected returns every single year is no doubt right. Regardless of their term period.
    But I believe that there are a few points that value investors overlooked.

    Below are the two major ones:

    1)Value investors put too much emphasis on the nature of a good business. But businesses are run by people. The trained astute eye is able to spot industrial trends affecting the business and pull out effectively, but most small LT investors are unable to influence the direction of the company. People are unpredictable and whats there to stop a certain director from being suddenly inspired to install...your fave, a golden tap? =] Or doing some creative accounting seems a good way to fund a new condo purchase.. If I remember correctly, the special buffet put himself on the board of his vested companies to "supervise" its LT business personally. How many of us are able to emulate that? Does that lead to a purchase-n-forget strategy to be more risky as your exposure to uncertainities(of human nature) is longer? Only one confident "bet" FOR a long term.... is that unecessary risk and ineffective usage of capital?

    2)A babe does not rise to its true value over a long period. It gets discovered every now and then as the market rotates its focus. This would cause periods of sharp rises in its price. I believe that seems to be the good time to be invested, when the gap of value is being filled. I know, that would take alot of watching and technicals on top of the fundamental work done to discovering the babe, but hey, whoever says whipping your money to work harder than yourself is an easy task? =] This also coincides with point one of reducing unecessary exposure to the market, which increases the risk of an investment unecessarily.

    It's not bad to revisit a purchase 10yrs later to see it grow 400%.... but it's not a bad idea either too to have it make 8-10% first and still be able to return to your bank in time to pay off that irritating utility bill? =]

    All capital have the same time but the one with the highest velocity covers the most distance.

    My 2 cents. =]

  4. Hi all, to add to the comments, I am also a value investor (my blog is at if you want to take a look).

    I think that value investing allows one to grow rich slowly, and to let your capital build up over time. By correctly applying the margin of safety concept, you minimize losing your principle and preserve your capital. Yes, I agree value investing is not a quick way to see wealth generated to pay stuff like utility bills or your handphone bill; but it's a slow method of accmumulating wealth.

    So far, I have only practised value investing for about a year plus, but the rewards are already beginning to show. I don't incur frictional costs trading in and out, don't have sleepless nights worrying about market trends and economic data; and don't have to keep checking prices daily.

    Businesses are run by people yes, and so we should invest with a degree of caution taking into account the quality and integrity of the people running the business. I personally make it a point to meet Management and executives of the companies I invest in, so as to get a feel of their attitudes towards shareholders. This is one way we can mitigate the risk.

    As to true value being realized over time, I believe that even witing 5 years is worth the wait, as the rewards can reap multi-baggers which means you only use a small amount of capital to grow it into a much larger base.

    Given a choice, I would have started value investing a lot earlier, instead of learning the "hard" way by trading.

  5. Risk and Diversification and is diversification good or bad, has been a topic of discussion, I got a post on that too.

    I think the conclusion wasn't clear on that post. But basically, for majority of investors, it's good, bcos we simply cannot be so sure about so many aspects of the businesses that we invest in.

    But for Buffett, and for those who are damn sure they know everything about the stocks they invested in. Then you need not diversify and your portfolio will still be on the efficient frontier.

    For me personally, I think I belong to the first camp. Hence I go for diversification.

  6. Hi all,

    My 2 cents worth here. I'm a value investor through and through. What I say is almost copy & paste from Buffett's tree of thoughts. But whoever says cloning is a shame, they know nothing that the best ideas in life usually comes from learning from what others have practised successfully. Very much liken to the reason why you go to school to get an education.

    First of all, Buffett only went on to be the CEO of a major company once which is Salomon Brothers when they were involved in some problems with SEC. But he discovered he wasn't the best man for the job and gave the seat to someone else within a year or less. The other where he got a board seat was in Coca Cola but he isn't at the board anymore because of some controversy.

    Anyway back to the subject, is there any other way besides value investing really? You have all other kinds of investing methods like tipster investing, dream investing, technical investing, industry-rotation investing. But what can you really understand out from those alternative investing method?

    Value investing means to get more from what you pay. How wrong can that goes? Even if you practiced any other method, velocity?, technical, I dare anyone who can name a single person who has practiced it successfully for a sustainable career (not a fly-by-night kind) and stand out and say that they have done it with proof. On the contrary, there're dozens of value investors I could easily name off the cuff.

    The thing about value investing is it will never be overrated. I'll be doomed and I should get worried when it gets overrated and practiced by the crowd which I know it will never happen. Firstly, it takes a lot to understand and control the emotional part of the human side in order to practice value investing in the right way. This is the most difficult part.

    Investing is akin to how you would operate a business. If you view it as only a number that is perpetually ticking on the counter, it doesn't tell anything about the business operation or what its value is compared to its share price.

    The thing about investing is if you buy a business at $80 whose value is actually $400 and if the stock had declined even further to a price that made the valuation $40 instead of $80, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 worth of value for $40 than $80.

    In investing time is your friend. And also to businesses, time is the friend of good businesses, and enemy of the bad businesses.

    For majority of the participants in the market, the best method is to buy into ETFs or indexes where overtime they will be able to gain as with the indexes. It is pointless to try to beat the index when the basis of foundation is weak. It is better to hop on a free car ride if you do not know how to drive or your direction around it.

  7. To musicwhiz:
    I'm happy for you that you haf found your "compass" to navigate urself through this investing sea as everyone is suited to diff style. May many good returns come for u ahead! But ever thought abt further refining ur investing technique? Like how to have a multi-bagger in less than 5 years? Or we always wished that we have invested more in a multi-bagger, so how do we make sure that our limited capital is always in the right place at the right time?
    Frictional costs from trading in and out is a small cost to pay to adjust ur risk level or for more gains. If u have try trading in and out b4 but unsuccessful, ever wonder why? Or try changing size? holding period? or questioning the factors why u got into a trade in the first place? Or why things dun work out? =]

    To Berkshire:
    It is certainly logical to buy something worth $400 for $40 and $80. But how sure are you that it is worth $400 and not $15? Counters everywhere in the world trading below NAV, Book value are not hard to find, but why are their prices always repressed? Every counter tells a story other than just plain financial ratios. To emulate Mr Buffet, it is not just enough to try to do what he has done and proven before. Thats just like our edu system - reproduction of knowledge. I rem Mr Buffet said b4 tat "diversification is for pple who dunno what they r doing." Do u agree? I believe it is better to understand his main points, know oneself own limitations and goals and devise a unique way to achieve it. =]

    The whole point of investing is to make money.
    Not market returns but own targeted returns as planned(unless u r the pegged type investor).
    The main objective of value investing is to take advantage of market discrepancy,
    i.e. buying counters that are "overlooked" by the market and holding them till market corrects itself, read: covering the value gap.
    IF investing is so simple as to just buy a good business and hold, all the hedge funds and institutional investors will be outperforming year after year without much work.
    What kind of resources do we have that they don't?
    Don't they know certain counters are undervalued as much as we do?
    They do. Certainly.
    But why, why are they not investing in it YET?
    What are they waiting for? =]

    Evolve we must, or we'll all become extinct.

  8. Woah woah, relax pple!

    Value investing or trading or other investment philosophy, no one philosophy is more superior. As long as you can earn a good return, go ahead and do it.

    80% of professional fund managers under-perform markets bcos of their time horizon. Their clients demand to see results every year. But value investing only give results after 3-5yrs at least. Sometimes they know there is a value gap, but they cannot act. Bcos the year closes in 5 mths. The gap may need years to close.

    ST investing can make you money too. There are legendary traders like Jesse Livermore. I am sure a lot of traders emulate him just like value investors emulate Buffett.

    I follow value investing to a certain extent but I also believe in diversification. It's really free for all in investment philosophy. Investment is about creativity. Maybe some day there could be another school of thought combining value and trading. Who knows?

  9. Hi Anonymous,

    I think you read pretty a lot about Mr. Buffett.

    To know if a company is really worth $400 instead of $15, then of course, you need to be able to think in the most business-like, not in the normal investment-type like as with what most market participants do or even big fund management institution. The most effective way in investing is to invest like a businessman.

    Yes, I agree that the diversification is for ppl for dunno what they're doing. Personally, I do not diversify. Since my funds are limited, I find it meaningless to split my funds into 3 or 4 shares where I would put some in my forth-most-like share instead of all into my-most-like share which I know it will return me the best return in the long run.

    It is tiring to keep on tracking the daily, monthly or half-yearly movement of share price and expect to beat all others who is in the game each and every time by trying to push the sell or buy button harder or faster than the next one who is trying to do so.

    Investing is never simple. It is easy but not simple. It takes a combination of understanding human psychology, emotional state, a normal intelligence, a keen motivation to keep reading and learning.

    Hedge funds and institutional investors are simply different from good intelligent investors. Firstly, there's a thing or emotional state termed institutional imperitive. When you have competiting colleagues or competitors who are in the same business trying to outdo each other, it is difficult to really practice value investing. For eg, if I am a trader in a big investment firm, and I find an undervalued stock and it sells for 40% below value but it takes time for the market to appreciate it. And every quarter, this bank publish quarterly report, and if I buy in the qtr before the coming report, I may show a negative or a flat result which may be under the market return for that quarter. But my colleague by tagging along with what the general mkt does, he or she will be able to show a result that is superior to mine because he or she simply buy the index. But come judgement day say a year later, the stock is finally appreciated fully, it shows 67% return compared to say 20% for the index for that particular year.

    But the thing with most financial places, they reward on quarter to quarter and no one will understand how could one buy something in a quarter that underperform the market.

    And even if the final result shows 67%, I as a trader in the bank will be died before i finally get a validation. Like the saying goes, you can be right in the long run but died in the short.

    There's a book I would recommend, it is called Bull by Maggie Mahar. It gives a very insightful understanding into the reason why people, hedge funds, institutional investors invest or react in certain ways.

  10. Hi everyone,

    I think there's no need to differentiate between the two so clearly. At the end of the day, there is a common goal - to make as much money as possible in the shortest time possible!