The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies

The financial ratios that make up the Return on Equity (ROE), Return on Assets (ROA), and Return on Invested Capital (ROIC) have been on my mind lately. Today I wanted to touch on Return on Equity. The DuPont return on Equity Model breaks down the components that drive profitability in a businesses. Let’s take a closer look at two businesses that generate fantastic Returns on Equity to see what makes them tick.


 

A little background on the businesses. Boston Beer Company and Brown-Forman are both wonderful businesses that generate incredible returns on equity and capital for their owners. They both produce high quality alcohol – beer and ciders primarily for Boston Beer Company and whiskey and spirits primarily for Brown-Forman. They are, in my opinion, run by competent and honest management teams. Both have either the founder or the founding family members control the businesses: Jim Koch, the founder of Boston Beer Company is the Chairman of the Board and controls all of the Class B voting shares, and the Brown family controls over 70% of the Class A voting shares of Brown-Forman corporation.

DuPont Model

Through the products they sell, they are able to generate strong ROE. Using the DuPont Model, we can break down the ROE into 3 basic components:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 1

The 3 figures above drive the returns a business generates. Let’s break them down further and use the full year financial figures from 2015 from the Boston Beer Company and Brown-Forman to see how these two generate their ROE.

Net Profit Margin

The net profit margin is the pure profit margin left after all costs and expenses related to the revenue generated by a business. We simply divide the net income (or net profit, whatever you prefer to call it) by the total revenue generated:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 2

For 2015, these were the net profit margins for Boston Beer Company:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 3

For 2015, these were the net profit margins for Brown-Forman:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 4

In the first leg of our calculations for ROE, we can see that Brown-Forman has a little over double the net profit margins of Boston Beer Company. The first thing that comes to mind is that whiskey takes much more time to create than beer, therefore as a producer of whiskey you would want to be compensated for the longer product development time than beer. But does this necessarily mean that Brown-Forman, with its superior profit margins, is the more profitable business?

Asset Turnover

While profit margins are important, we need to look at how those profits are generated. A lower net profit margin doesn’t necessarily mean that the business is not as profitable in a total sense. Let me show you what I mean by look at the asset turnover rate.

Asset turnover demonstrates how effectively a company converts its assets into revenue. This is how it is calculated:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 5

This ratio tends to be inversely related to the net profit margin – high asset turnover is typically paired to lower net profit margins (lower profit, higher volume businesses) and low asset turnover is typically paired to higher net profit margins (higher profit, lower volume businesses). We are about to see exactly this in the examples of Boston Beer Company and Brown-Forman.

For 2015, this was the asset turnover rate for Boston Beer Company:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 6

For 2015, this was the asset turnover rate for Brown-Forman:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 7

Notice something interesting? Just as predicted before we calculated the asset turnover rate, Boston Beer Company has a higher asset turnover rate than Brown-Forman! Interestingly, when it comes to asset turnover, it is now Boston Beer Company’s turn to double the rate of a ratio; Brown-Forman had double the net profit margin but Boston Beer Company has double the asset turnover rate.

Our assumption that whiskey takes longer to develop as opposed to beer and cider is clearly demonstrated by the asset turnover figures for the two businesses. What makes this so fascinating is that even though Brown-Forman can sell its products at double the profit margins of Boston Beer Company, Boston Beer Company can generate double the sales from its assets, making up for the profit margin lose to Brown-Forman. It would have been premature to declare Brown-Forman the more profitable business purely based on net profit margins. The asset turnover rate will show further how a business is generating its profits and sales.

Return on Assets

Let’s do a slight detour from the DuPont Model to take a quick look at the ROA, which can be calculate as follows:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 8

ROA is two-thirds of the DuPont Model for calculating ROE. The equity multiplier, which we haven’t calculated yet, will show the amount of leverage a business employs. ROA will show what a business generates without the use of leverage. ROA will also allow you to see how asset intensive a business is:

The return on assets figure is also a sure-fire way to gauge the asset intensity of a business.  The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy while anything above 20% is asset-light.

In 2015, the ROA for Boston Beer Company was:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 9

In 2015, the ROA for Brown-Forman was:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 10

Again, just as we talked about earlier, the lower net profit margin for the Boston Beer Company was made up by the higher asset turnover relative to Brown-Forman. Without taking into account the leverage employed, we can see that both companies generate almost identical Return on Assets. Whereas Brown-Forman takes longer to sell its products but commands a higher profit margin, Boston Beer Company sells its products more quickly at a lower profit margin.

As you can see, you can’t judge a business purely by its profit margins: there are other factors at work driving the total profitability of the enterprise.

Equity Multiplier

Let’s now take a look at the third and final component of the DuPont Model for calculating ROE, the equity multiplier. The equity multiplier measures financial leverage and allows us to see what portion of the ROE is due to debt. It is calculated as follows:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 11

By taking the assets and dividing it by the shareholder’s equity, we can see what effect debt has on the ROE.

In 2015, this was the equity multiplier rate for Boston Beer Company:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 12

In 2015, this was the equity multiplier rate for Brown-Forman:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 13

We can see that Brown-Forman employs more debt in its capital structure than Boston Beer Company. In fact, if you guy take a glance at the 2015 balance sheet for both companies, you will see the connection as Brown-Forman has more debt, relatively speaking, than Boston Beer Company. In fact, Boston Beer Company doesn’t employ any long-term debt.

This on its own doesn’t tell us much – we need to dig further into the balance sheet and the annual report to understand how the debt structure works and why debt is being employed. From an article on the equity multiplier:

This is not to say that debt is always bad.  In fact, debt is an important part of optimizing the capital structure of a firm to generate the best trade-off between return on capital, growth, and trade-offs as it pertains to equity dilution.  Certain industries, such as regulated utilities and railroads, almost require debt as a matter of course.  Additionally, the corporate bonds that arise are an important backbone of the economy, providing a way for financial institutions such as property and casualty insurance companies, university endowments, and non-profits to put surplus assets to work generating interest income.

Rather, the problem arises when financial engineering goes too far.  It isn’t unusual for a private equity fund to buy a business, load it down with debt, extract all of the equity, and leave it hobbled under enormous interest expense payments that threaten its solvency.  In certain cases, these businesses go public again through an IPO and are then forced to spend years using earnings and freshly raised capital to heal the damage.

Another article does a good job explaining the leverage portion of ROE:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 14

The ROE merely tells us how much debt is being employed, not how effective it is, and that’s a problem because:

ROE can obscure a lot of potential problems. If investors are not careful, it can divert attention from business fundamentals and lead to nasty surprises. Companies can resort to financial strategies to artificially maintain a healthy ROE — for a while — and hide deteriorating performance in business fundamentals. Growing debt leverage and stock buybacks funded through accumulated cash can help to maintain a company’s ROE even though operational profitability is eroding. Mounting competitive pressure combined with artificially low interest rates, characteristic of the last couple of decades, creates a potent incentive to engage in these strategies to keep investors happy.

Excessive debt leverage becomes a significant albatross for a company when market demand for its products heads south, as many companies discovered during the current economic downturn. It actually creates more risk for a company in hard times.

We’ll have to re-visit the topic of debt and how effectively and efficiently a business employs it another day as it is a whole other can of worms.

DuPont Return on Equity

Now that we have solved for the 3 components of the DuPont ROE model, we can go ahead and calculate what the ROE is for both businesses. All we have to do is multiply the 3 figures together:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 15

For Boston Beer Company in 2015, the ROE was:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 16

For Brown-Forman in 2015, the ROE was:

The DuPont Return on Equity Model: Boston Beer & Brown-Forman as Case Studies 17

We saw earlier above that both businesses had almost identical ROA ratios, which suggests that stripped of all debt, both businesses are almost on par in terms of profitability. However, the additional debt that Brown-Forman employs allows it have a much higher ROE ratio, 34.37% vs 21.30%.

Before we got any further, you may be wondering what ROE even measures. Borrowing from this article on ROE:

Return on equity reveals how much after-tax profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners…

A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better provided it isn’t achieved with extreme risk. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth(shareholder’s equity) of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity ($5 ÷ $100 = .05, or 5%)…

Return on equity is particularly important because it can help you cut through the garbage spieled out by most CEO’s in their annual reports about, “achieving record earnings”. Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report “record earnings” because of the interest earned. Were the shareholders better off? Not at all.  They would have enjoyed heftier returns had the earnings been paid out as cash dividends.

This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management’s fiscal adeptness than the annual earnings per share in isolation.

Conclusion

The DuPont ROE Model was very useful in telling us how the ROE is generated for a business by taking the 3 main components that make up ROE. By using this model, we are able to “look under the hood” of a business to see how they generate returns on equity in the business.

Somethings to keep in mind when analyzing ROE include:

  1. Analyze and compare businesses within the same industry.
  2. Abnormal ROE relative to the industry will require a close scrutiny of the financial statements to see what’s going on.
  3. Look at a long history of ROE and its components to see whether they have remained steady and growing or diminishing to spot trends.
  4. Understand how effective the leverage being employed in the equity multiplier calculation truly is.

The third and final point is the concept I’d like to expand and explore further next time. Until we can fully grasp how debt is being utilized, we can’t fully state that Brown-Forman is the hands-down superior business based on how they generate profits. We can say that based on looking at the ROE, Brown-Forman currently does appear to be the superior business, granted the debt they employ is being employed intelligently.

Since if we strip away the debt, the ROA being generated is almost identical, we will need to take a deeper look at the debt structure and how it is used to come to a more conclusive conclusion on which company is the more profitable enterprise.

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