The three levers of ROE are:
- net profit margin (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)
But does it matter if a company's high ROE comes from high debt and not operating efficiency?
If a company has a steady or steadily growing business, it might not matter that much.
For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem. And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.
If a company's business is cyclical or volatile in some other way, though, watch out.
The problem is that debt comes with fixed costs in the form of interest payments. The company has to make those interest payments every year, whether business is good or bad.
When a company increases debt, it increases its fixed costs as a percentage of total costs.
In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.
When business is bad, however, the fixed costs of debt push earnings even lower.
That is why debt is sometimes referred to as leverage: It levers earnings, making strong earnings stronger and weak earnings weaker.
When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.
So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).
You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.
- net profit margin (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)
But does it matter if a company's high ROE comes from high debt and not operating efficiency?
If a company has a steady or steadily growing business, it might not matter that much.
For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem. And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.
If a company's business is cyclical or volatile in some other way, though, watch out.
The problem is that debt comes with fixed costs in the form of interest payments. The company has to make those interest payments every year, whether business is good or bad.
When a company increases debt, it increases its fixed costs as a percentage of total costs.
In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.
When business is bad, however, the fixed costs of debt push earnings even lower.
That is why debt is sometimes referred to as leverage: It levers earnings, making strong earnings stronger and weak earnings weaker.
When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.
So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).
You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.
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