Edison International (NYSE: EIX) generated a below average return on equity of 4.0% over the past twelve months, while the Utilities sector returned 8.4%. Even though Edison’s performance is subpar relative to its peers, it’s useful to understand what’s really driving the company’s low ROE and how it’s trending. Understanding these components may change your views on Edison and its future prospects.
Edison’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
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.
Edison’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
The return on equity of Edison has generally been declining over the last few years. ROE decreased from 14.1% to 7.7% in fiscal year 2015, increased to 9.5% in 2016 and decreased to 4.0% in 2017. So what’s causing the general decline?
What’s Driving Edison’s Declining Return On Equity
The DuPont analysis is simply a separate way to calculate a company’s ROE:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
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 Edison’s returns.
Edison’s Net Profit Margin
The net profit margin of Edison has generally been declining over the last few years. Margins had reached 12% in fiscal year 2014 but have since dropped to 4.6%.
Therefore, the company’s decreasing margins help explain, at least partially, why ROE is also decreasing. Now let’s take a look at Edison’s efficiency performance.
Edison’s Asset Turnover
It appears that asset turnover of Edison has generally been increasing over the last few years. Turnover increased slightly to 0.23x in fiscal year 2016 and increased again to 0.24x in 2017.
source: data explorer – asset turnover
As a result, the company’s declining ROE is not due to its asset turnover performance which has generally been increasing.
Finally, the DuPont constituents that make up Edison’s ROE are shown in the table below. Note that the table also compares Edison to a peer group that includes FirstEnergy Corporation(NYSE: FE), Entergy Corporation (NYSE: ETR), American Electric Power Company, Inc. (NYSE: AEP) and PG&E Corporation (NYSE: PCG).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Edison’s general decline in return on equity is the result of a worsening net profit margin, an improving asset turnover ratio and declining leverage. Therefore when looking at the core operations of the business, Edison shareholders do not need to be too concerned due to the company’s general improvement in operational efficiency and declining leverage.
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 Edison to gain a better understanding of its fundamentals before making an investment decision.
Author: Matt Hogan
Expertise: Valuation, financial statement analysis
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.
Matt can be reached at email@example.com.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.