Nike Inc (NYSE: NKE) delivered an outstanding 32.1% ROE over the past year, compared to the 8.8% return generated by the Consumer Discretionary sector. Nike’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 Nike’s performance and future prospects. I show you exactly what I mean in my DuPont analysis below.
How To Calculate Nike’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 Nike over the last few years is shown below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Nike has generally been increasing over the last few years. ROE increased from 27.8% to 30.1% in fiscal year 2016, increased to 34.4% in 2017 and decreased to 32.1% as of LTM Nov’17. So what’s causing the general improvement?
Understanding Nike’s Improving 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 Nike’s improving returns?
Net Profit Margin Trends
It appears that the net profit margin of Nike has generally been increasing over the last few years. Margins increased from 10.7% to 11.6% in fiscal year 2016, increased to 12.3% in 2017 and decreased to 11.1% as of LTM Nov’17.
Therefore, the company’s increasing margins help explain, at least partially, why ROE is also increasing. Now let’s take a look at Nike’s efficiency performance to see if that is also boosting ROE.
Asset Turnover Trends
It appears that asset turnover of Nike has generally been declining over the last few years. Turnover decreased from 1.52x to 1.51x in fiscal year 2016, increased to 1.54x in 2017 and decreased to 1.49x as of LTM Nov’17.
source: data explorer – asset turnover
Therefore, the company’s ROE improvement is not as a result of its asset turnover performance which has generally been decreasing.
Finally, the DuPont constituents that make up Nike’s ROE are shown in the table below. Note that the table also compares Nike to a peer group that includes TJX Companies, Inc. (The)(NYSE: TJX), Under Armour, Inc. (NYSE: UAA), adidas AG (NYSE: ADDYY) and Gap, Inc. (The)(NYSE: GPS).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Nike’s general improvement in return on equity is the result of an improving net profit margin, a declining asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Nike shareholders may need to start worrying due to the company’s general improvement in 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. But before making an investment decision, I recommend you continue to research Nike to get a more comprehensive view of the company by looking at:
Valuation Metrics: what is Nike’s price to book ratio and how does it compare to its peers? Analyze Price / Book here.
Risk Metrics: what is Nike’s CapEx coverage? This is the amount a company outlays for capital assets for each dollar it generates from those investments. View the company’s CapEx coverage here.
Efficiency Metrics: inventory turnover is a ratio that measures the number of times a company’s inventory is sold and replaced over the year. View Nike’s inventory 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.