Target Corporation (NYSE: TGT) generated an outstanding return on equity of 23.9% over the past twelve months, while the Consumer Discretionary sector returned 8.8%. Even though Target’s performance is highly impressive relative to its peers, it’s useful to understand what’s really driving the company’s strong ROE and how it’s trending. Understanding these components may change your views on Target and its future prospects.
Target’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.
Target’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Target has generally been increasing over the last few years. ROE increased from -10.8% to 25.0% in fiscal year 2016, decreased to 22.9% in 2017 and increased to 23.9% as of LTM Oct’17. So what’s causing the general improvement?
What’s Driving Target’s Improving 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 Target’s returns.
Target’s Net Profit Margin
The net profit margin of Target has generally been declining over the last few years. Margins increased from -2.3% to 4.6% in fiscal year 2016, decreased to 3.9% in 2017 and decreased again to 3.8% as of LTM Oct’17.
Therefore, the company’s ROE improvement is not as a result of its net profit margin performance which has generally been decreasing. Then could the increasing ROE be a result of improving efficiency?
Target’s Asset Turnover
It appears that asset turnover of Target has generally been declining over the last few years. Turnover increased from 1.69x to 1.81x in fiscal year 2016, decreased to 1.79x in 2017 and decreased again to 1.76x as of LTM Oct’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 Target’s ROE are shown in the table below. Note that the table also compares Target to a peer group that includes Dollar General Corporation(NYSE: DG), Wal-Mart Stores, Inc. (NYSE: WMT), Big Lots, Inc. (NYSE: BIG) and Dollar Tree, Inc. (NASDAQ: DLTR).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Target’s general improvement in return on equity is the result of a worsening net profit margin, a declining asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Target shareholders should not be too excited due to the company’s general decline 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. 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 Target to gain a better understanding of its fundamentals before making an investment decision.
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.