Verisk Analytics, Inc. (NASDAQ: VRSK) delivered an outstanding 34.1% ROE over the past year, compared to the 10.1% return generated by the Industrials sector. Verisk’s results may indicate management is running a highly efficient business relative to its peers, which may very well be the case, but it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components may change your view on Verisk’s performance and future prospects. I show you exactly what I mean in my DuPont analysis below.
How To Calculate Verisk’s ROE
Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. Return on Equity or ROE is generally calculated using the following formula:
ROE = Net Income To Common / Average Total Common Equity
ROE is a helpful metric that illustrates how effective the company is at turning the cash put into the business into gains or returns for investors. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
The return on equity achieved by Verisk over the last few years is shown below.
source: finbox.io data explorer – ROE
Unfortunately for shareholders, Verisk’s return on equity has decreased each year since 2015. ROE decreased from 64.1% to 43.7% in fiscal year 2016, decreased to 34.1% in 2017 and the LTM period is also its latest fiscal year. So what’s causing the steady decline?
Understanding Verisk’s Declining Return On Equity
The DuPont analysis is another way to calculate a company’s ROE using the following three metrics:
Return on Equity = Net Profit Margin * Asset Turnover * Equity Multiplier
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 what exactly is causing Verisk’s declining returns?
Net Profit Margin Trends
It appears that the net profit margin of Verisk has generally been increasing over the last few years. Margins increased from 28.8% to 29.6% in fiscal year 2016, decreased to 25.9% in 2017 and the LTM period is also its latest fiscal year.
As a result, the company’s declining ROE is not due to its net profit margin performance which has generally been increasing. Could the poor ROE performance be a result of declining efficiency?
Asset Turnover Trends
It appears that asset turnover of Verisk has generally been declining over the last few years. Turnover decreased from 0.44x to 0.39x in fiscal year 2016, increased to 0.40x in 2017 and the LTM period is also its latest fiscal year.
source: data explorer – asset turnover
Therefore, the company’s decreasing asset turnover ratio helps explain, at least partially, why ROE is also decreasing.
Finally, the DuPont constituents that make up Verisk’s ROE are shown in the table below. Note that the table also compares Verisk to a peer group that includes TransUnion (NYSE: TRU), Dun & Bradstreet Corporation (The) (NYSE: DNB), Equifax, Inc. (NYSE: EFX) and MSCI Inc(NYSE: MSCI).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Verisk’s continuous fall in return on equity is the result of an improving net profit margin, a declining asset turnover ratio and declining leverage. Therefore when looking at the core operations of the business, Verisk shareholders do not need to be too concerned due to the company’s general improvement in profitability along with a general decline in operational efficiency and declining leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. But before making an investment decision, I recommend you continue to research Verisk to get a more comprehensive view of the company by looking at:
Valuation Metrics: what is Verisk’s short ratio and how does it compare to its publicly traded peers? It represents the percentage of total shares outstanding that is being shorted. View the short ratio here.
Risk Metrics: how much interest coverage does Verisk have? This is a ratio used to assess a firm’s ability to pay interest expenses based on operating profits (EBIT). View the company’s interest coverage here.
Efficiency Metrics: fixed asset turnover is calculated by dividing revenue by average fixed assets. View Verisk’s fixed asset turnover here.
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.