Tesco has had a rough ride over recent years, issuing a series of profit warnings while the CEO has been ousted and the dividend has been cut. Meanwhile, brokers have consistently downgraded their earnings estimates and the share price has fallen by nearly 50% over the past two years (to around £1.88). The company has not traded at these levels since the early 2000s. Hindsight is a beautiful thing, but it isn’t necessarily useful in the stockmarket. Investors need to know about the bad news before share prices collapse.

Was there any writing on the wall? At a first glance - apparently not. Tesco sustained a high return on equity from 2006 through the recession until 2012, when the company issued its first profit warning. Even so, there were red flags lurking behind these numbers. A useful tool to spot them is the DuPont formula which helps investors deconstruct the drivers behind the RoE. Let’s explore this further...

What is the DuPont formula?

Return on equity (RoE) reveals how much profit a company generates compared to the total amount of equity on its balance sheet. On one hand, a high RoE can signal high profitability,  but the ratio can be misleading because even if profits remain flat, a company can generate a higher RoE by taking on more borrowing. This can reduce the size of the denominator (ie. equity) compared to the numerator (ie. net income).

To overcome this problem, the DuPont formula breaks a company’s RoE into three parts (see below) and enables investors to identify the source of superior (or inferior) returns.

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Generally speaking, a high RoE could come from three sources:

High Net Margins: Companies with a strong business franchise may be well placed to sell a product at a higher price than the costs incurred during the production process. These companies typically generate strong Profit Margins relative to their peer group.

High Asset Turnover: Some companies, particularly retailers, sell products with low profit margins. However, they sell their products in large volumes and thereby generate a high Asset Turnover - the amount of sales relative to the assets needed to create those sales.

High Leverage: Revenues and profit margins sometimes plateau or even shrink. When this happens, companies can still generate strong returns by using leverage, as we mentioned above - albeit at higher risk.


Analysing Tesco

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