11.2.3. The structure of profitability: the relationship between the return on equity and operating profitability
Based on the structure ROIC, the return on invested capital grows if the numerator grows, i.e. profit before interest and taxes, or otherwise - operating profit, and the denominator is reduced, i.e. the invested capital decreases. In this regard, the turnover of invested capital or the turnover of net assets is defined as a measure of the efficiency with which the invested capital or net assets are used.
ROI C and DuPont principle. To determine the factors of growth in operating profitability, the same Du Pont principle is applied, and operational profitability is broken down into two factors:
where И01С - operational profitability; EBT- profit before interest and taxes; 5 - sales volume.
In this equation, the first factor is the rate of operating profit, and the second is the turnover of invested capital. Thus, operational profitability is a product of the norm of operating profit and turnover of invested capital, while the dependencies are directly proportional: higher operating profitability is due to higher operating margin and turnover of invested capital. In turn, the norm of operating profit grows if prices or sales increase, or expenses decrease faster than sales grow. Higher turnover of invested capital is achieved through the effective use of net assets.
The key factors are YaC. Figure 11.10 shows key factors for the growth of return on invested capital. They are formed as a result of the interaction of a higher rate of operating profit and a faster turnover of invested capital.
Fig. 11.10. Key factors of growth of return on invested capital
Fig. 11.10. Key factors for growth in return on invested capital (continued)
In addition to the specific characteristics of the market in which this business competes (the level of innovation activity and technological change, the relative power of consumers and the growth rate of the market), three factors should also be considered: the relative quality of products; relative market share; structure of assets and costs (in particular, the compositional structure of assets and their concentration, cost structure, level of vertical integration, etc.).Summing up, it should be pointed out that a high market share and the highest quality of the product on average lead to an increase in operating profitability, and high investments and high fixed costs on average reduce this profitability.
To understand this relationship, it is sufficient to consider the case when a company does not have loans at all and finances its existence only at the expense of its own capital. In this case, the problem arises of establishing a link between pre-tax return on equity and pre-tax operating income. If there are no loans, there are no interest payments. Thus, the pre-tax profit or profit before tax must be equal to the profit before interest and taxes. Further, if assets are financed only at the expense of own capital, the invested capital should be equal to own capital. In other words, if there are no loans, the return on equity is equal to the operating profitability.
Return structure: ROE and ROIC. In determining the return structure, you should consider the relationship between the two main indicators of return: ROE and ROIC. This relationship is mediated by the interaction of five factors: the rate of operating profit, the turnover of invested capital, the coefficient of financial value, the ratio of the financial structure and the coefficient of the tax effect. The relationship between them and the return on equity is the most direct: the aggregate profitability of a company is the product of all five factors - the rate of operating profit, the turnover of invested capital and the coefficients of the financial multiplier, the financial structure and the tax effect.
The structure of the company's profitability using operating profit can be represented as follows:
Return on equity = Profit after taxes/Equity = Profit before interest and taxes/Sales x Sales/Invested capital x Profit before taxes/Profit before interest and taxes x Invested capital/Equity x x Profit after taxes/Profit before taxes,
where ROE- return on equity; EAT- profit after tax; E- own capital; 1C - invested capital; SALES - sales; EAT- profit before tax; EBIT - Profit before interest and taxes.
Multiplier financial leverage as a measure of financial policy. The first two factors - the operating profit margin and the turnover of invested capital - reflect the contribution of investment and operating decisions to the total return. This contribution is measured by operating profitability. The third and fourth factors - financial structure and financial value - reflect the impact of the company's financial policy on its aggregate profitability. We call this impact the multiplier of the financial leverage. Thus,
Financial leverage multiplier = Financial value ratio х х Financial structure factor. (11.39)
Tax effect. The coefficient of the tax effect reflects the contribution of corporate tax policy to the return on equity and is equal to
1 - Effective tax rate. We rewrite the equation using the new terminology:
ROE = ROIC x Financial leverage multiplier x
x (1 - Effective tax rate), (11.40)
where ROE - return on equity; ROIC - return on invested capital.
So, let's sum up.
1. Pre-tax ROE = ROIC x Multiplier financial leverage. If we are given the cost of debt and given the ratio of debt to equity, then
where t - the effective tax rate; COD - The cost of debt.
2. If we want to consider the relationship between ROE and ROIC after paying taxes, then using the abbreviations and relationships (EBYG - earnings before interest and taxes, EAT- profit after taxes, t - effective tax rate, D - debt or total loans, 1C - invested capital , COD - the value of the debt, COD x D - interest payments, ROE = -, ROIC = -), we get the following
expression: ^ ^
Using a series of replacements, we get:
and, dividing both sides of the last equation into the capital of the owners (E), we get:
where the relationship ROE and ROIC is mediated by such important categories of modern financial management as the yield spread (ROIC-COD), Effective tax rate (t) and financial leverage (D/E ).
And again the DuPont model. The combined yield is divided into several simple financial ratios. Such disaggregation is still used everywhere in financial management. This idea arose in the 1920s. and belonged to Donaldson Braun, who compiled this formula while working for the company "Du Pont de Nemours", and then applying her as vice president of finance at "General Motors".
The main purpose of this formula was not very difficult: to see the sources or, otherwise, the return on assets.
This is the historically original, original form of the Dupont formula, illustrated in Fig. 11.11.
Fig. 11.11. Key asset return factors
Like most types of coefficient financial analysis, DuPont's formula matters not only and not so much because it provides answers to existing questions. It raises new questions and requires new answers. If the company increases the profitability of assets, finding ways to reduce working capital, the efficiency of its activities will be higher. Reducing capital costs in the short term will also have an effect and will positively influence the return on assets. And not only the denominator will decrease in the asset turnover ratio, but the profitability of sales will increase as a result of lower depreciation charges in the current year. Under-investment, of course, will lead to a decrease in competitiveness and a drop in the long-term return on assets. Thus, financial managers should look for true solutions in which both current and strategic interests of the company would be combined.
Analysis using the DuPont formula, and now conducted in companies, confirms the importance of studying the basic parameters of the return on assets. If you rely solely on the yield of your own captal in the analysis, many companies (especially within the same industry) will be very similar. However, the management methods will be different. There are companies that, with a low rate of profit, rely on a high turnover of assets. In others, on the contrary, the ratio of these coefficients is directly opposite.
Some companies are distinguished by relatively high return on equity. It should always be remembered here that such excess, as a rule, is due to a more aggressive financial leverage. And investors should not forget: higher aggregate profitability is accompanied by increased financial risks. There is another rather typical situation, sometimes causing analysts and managers to be perplexed. It means absurdly high profitability, which, by the way, is quite common in United States companies. In part, similar results reflect a very high financial leverage and, accordingly, a policy of large borrowings. But there is one more reason for this phenomenon: a lower book value. Return on equity is not so high: (a) when equity is considered not in terms of historical value, but in terms of market capitalization; b) when the financial statements are transformed in IFRS format.
Arguments about the interaction of financial leverage and aggregate profitability arose on the basis of the modified Du Pont formula. In disaggregation of aggregate profitability, one more step was taken. With the help of the new investment version of DuPont's formula, in due time, the factors of profitability of the funds invested in the company by its shareholders were analyzed:
Spheres of application of the Dupont model. The stock market usually gives a lower estimate of revenues, because it takes risks into account. The financial risk caused by financial leveraging significantly affects the market multiplier. Any analyst will treat the company more favorably if it seeks to increase its profitability by increasing the profitability of its assets, rather than through aggressive leverage of share capital. In addition to increasing volatility in the rate of profit, an increase in the amount of debt demonstrates the powerlessness of management in managing operations. Moreover, a company that has already fully utilized its financial potential can not resort to borrowing in the future. At the same time, the company, which has reserves to attract borrowed capital, hides in a sense its potential for profitability growth. In fact, Dupont's modified formula allows investors to assess the quality of return on equity. The investment version of Dupont's formula is often called the financial test of qualitative diagnostics.
This formula has one more scope. It helps to determine the potential for incremental value of the company through restructuring the company - either through internal measures or through externally imposed actions associated with changing operational and financial strategies. The analysis, carried out with the help of Du Pont's formula, allows us to discover the potential for increment in value. The point is that some companies have the opportunity to raise their capitalization, for example, by using assets more efficiently, while other companies increase their financial leverage for the same purpose.
In this regard, between managers and investors, there are constant frictions over corporate financial policies. Managers generally prefer to create reserves, for example, in case of a crisis or other unforeseen circumstances. They are less worried about the spending of unnecessary denets and prefer to live with relatively modest incomes, but at low risks. Managers are convinced: it is better to hold this money in case of falling incomes and cash flows. Investors, on the contrary, prefer to spend this money profitably: either by issuing their own shares, or by returning to shareholders their investments in the form of dividends.
Operational and financial policies. For many years, the discussion between managers and shareholders about the correlation of operational and financial policies has changed its content. In 1927, one of the first financial analysts convinced the management of a large company to liquidate certain assets that were not related to its core business and distribute the money received among shareholders. The result was unexpected. Institutional investors did not support this decision of managers and sold their shares. In fact, the same situation developed in the 1980s. The main advisors to corporate governance were aggressive financial managers, who preferred to borrow rather than restructure. 1970s. were marked by a wave of absorption. Special absorption was obtained in the 1980s. They were based on exorbitant loans. Garbage Bonds ( Junk bonds ) were used as a source of financing. Active operations LBO (leverage buy-out - the repurchase of shares due to loans) were actively developed. Only later, in the 1990s. institutional investors began to understand that the growth of the stock price can also be influenced by operational measures, for example, divestiture. Shareholder activity, which increased in the 1990s, led to an increase in market multiples. In addition, this period became an alternative to the past period, when the main focus was on the growth of financial leverage. It was the 1980s that became the era of the repurchase of shares through loans. Control was won by buying up stocks at bargain prices, after which the structure of capital changed dramatically due to a significant increase in the share of loans. And M & A specialists focused on financial leverage.
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