Capital One Financial Corp. (NYSE: COF) underperformed the Financials sector by -4.7% as it relates to ROE, producing a low 3.5% compared to the sector’s 8.3%. But what is more interesting is whether Capital One will continue to post subpar returns moving forward. The DuPont analysis is a useful tool that may help us determine this. In my analysis below, I’ll use the DuPont model to reveal what’s really driving the company’s low ROE.
Capital One’s ROE Trends
Return on equity or ROE represents the percentage return a company generates on the money shareholders have invested.
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 impacted by management’s financing decisions such as the deployment of leverage.
Capital One’s recent ROE trends are illustrated in the chart below.
source: finbox.io data explorer – ROE
Unfortunately for shareholders, Capital One’s return on equity has decreased each year since 2015. ROE decreased from 8.4% to 7.4% in fiscal year 2016, decreased to 3.5% in 2017 and the LTM period is also its latest fiscal year. So what’s causing the steady decline?
What’s Causing Capital One’s Declining Return On Equity
A less used approach although being much more intuitive, the DuPont formula is another way to calculate a company’s ROE. It is defined as:
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 causing Capital One’s declining returns.
Capital One’s Net Profit Margin Trends
Unfortunately for shareholders, Capital One’s net profit margin has decreased each year since 2014. Margins decreased from 15.5% to 12.8% in fiscal year 2016 and decreased again to 5.7% in 2017.
As a result, the company’s worsening margins help explain, at least in part, why ROE continues to decline. However, let’s also take a look at Capital One’s efficiency.
Capital One’s Asset Turnover Trends
It appears that asset turnover of Capital One has generally been declining over the last few years as illustrated in the chart below.
source: data explorer – asset turnover
As a result, the company’s declining ROE is also due to its asset turnover performance which has generally been declining.
Finally, the DuPont constituents that make up Capital One’s ROE are shown in the table below. Note that the table also compares Capital One to a peer group that includes American Express Company (NYSE: AXP), U.S. Bancorp (NYSE: USB), Discover Financial Services (NYSE: DFS) and PNC Financial Services Group, Inc. (The) (NYSE: PNC).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Capital One’s continuous fall in return on equity is the result of a steadily deteriorating net profit margin and asset turnover ratio. Therefore when looking at the core operations of the business, Capital One shareholders have reason to be concerned due to the company’s deteriorating profitability along with a general decline in operational efficiency and increasing 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 Capital One to gain a better understanding of its fundamentals before making an investment decision.
Author: Brian Dentino
Expertise: financial technology, analyzing market trends
Brian is a founder at finbox.io, where he’s focused on building tools that make it faster and easier for investors to research stock fundamentals. Brian’s background is in physics & computer science and previously worked as a software engineer at GE Healthcare. He enjoys applying his expertise in technology to help find market trends that impact investors.
Brian can be reached at email@example.com.
As of this writing, Brian did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.