Apple Inc. (NASDAQ: AAPL) generated an excellent return on equity of 37.1% over the past twelve months, while the Information Technology sector returned 3.8%. While Apple’s performance is highly impressive relative to its peers, it’s useful to understand what’s really driving the company’s strong ROE and how it’s trending. Understanding these components may change your views on Apple and its future prospects.
Apple’s Return On Equity
Return on equity represents the percentage return a company generates on the money shareholders have invested. Return on Equity or ROE is defined as follows:
ROE = Net Income To Common / Average Total Common Equity
In general, a higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
Apple’s historical ROE trends relative to its peers are highlighted in the chart below.
The return on equity of Apple has generally been declining over the last few years. ROE decreased from 46.2% to 36.9% in fiscal year 2016, stayed there in 2017 and slightly increased to 37.1% as of LTM Dec’17. So what’s causing the general decline?
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s driving Apple’s returns.
Apple’s Net Profit Margin
The net profit margin of Apple has generally been declining over the last few years. Margins decreased from 22.8% to 21.2% in fiscal year 2016, decreased slightly to 21.1% in 2017 and stayed there as of LTM Dec’17.
Therefore, the company’s decreasing margins help explain, at least partially, why ROE is also decreasing. Now let’s take a look at Apple’s efficiency performance.
Apple’s Asset Turnover
Unfortunately for shareholders, Apple’s asset turnover has decreased each year since 2015. Turnover decreased from 0.9x to 0.7x in fiscal year 2016, decreased slightly in 2017 and decreased again to 0.6x as of LTM Dec’17.
In conclusion, the DuPont analysis has helped us better understand that Apple’s general decline in return on equity is the result of a worsening net profit margin, a declining asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Apple shareholders have reason to be concerned due to the company’s general decline in profitability along with deteriorating operational efficiency.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research Apple to gain a better understanding of its fundamentals before making an investment decision.
Matt Hogan is also a co-founder of finbox.io. His expertise is in investment decision making. Prior to finbox.io, Matt worked for an investment banking group providing fairness opinions in connection to stock acquisitions. He spent much of his time building valuation models to help clients determine an asset’s fair value. He believes that these same valuation models should be used by all investors before buying or selling a stock.