The three levers of ROE are net margin, asset turnovers and financial leverage.
Not all the 3 levers of ROE are made equal.
The first two levers, net margin and asset turnover, are measures of how efficient a company's operations are.
Increasing net margins - which means a company is turning a larger portion of its sales into profits - will increase profitability.
A high asset turnover, which expresses how many times a company sells, or turns over its assets, in a year is also a sign of efficiency.
The product of net margin and asset turnover is called return on assets, or ROA, and it is an excellent measure of operational profitability.
ROA = Net Profit Margin x Asset Turnover
The higher a company's ROA, the better.
Some companies emphasize high net margins to pump up their ROA; others emphasize rapid turnover.
For example:
Coca Cola KO
Between 1994 and 1998, Coke's net margins averaged 18%.
Coke was able to leverage its strong brand name into higher prices, resulting in fat net margins.
Cott COTTF, a Canadian produce of discount, non-brand-name soda.
Cotts's average net margin was less than 5%.
Cott, on the other hand, targeted the low end of the market with bargain prices, earning a slimmer profit margin on each sale but (hopefully) moving a lot more merchandise per unit of assets.
Cott's asset turnover during the same period was 1.7, compared with Coke's 1.1. But that wasn't nearly enough to offset Coke's much higher net margins, and Coke's ROA of 24% trounced Cott's 4%.
This is not to say that focusing on asset turnover at the expense of margins is always a bad thing.
Wal-Mart WMT
Wal-Mart WMT has lower margins than most other major retailers because it emphasizes lower prices.
But Wal-Mart also generates a higher ROA than most of these competitors because it operates so efficiently that its asset turnover is much higher.
In 1998, for example, Wal-Mart''s asset turnover was 2.8, as opposed to 1.1 for old-line retailer Sears S and 2.0 for rival discounter Dayton-Hudson DH.
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