Microsoft Corporation (NASDAQ: MSFT) delivered an above average 13.0% ROE over the past year, compared to the 3.8% return generated by the Information Technology sector. Microsoft’s results may indicate management is running an 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 Microsoft’s performance and future prospects. I show you exactly what I mean in my DuPont analysis below.
How To Calculate Microsoft’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 Microsoft over the last few years is shown below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Microsoft has generally been increasing over the last few years. ROE increased from 14.4% to 22.1% in fiscal year 2016, increased to 29.4% in 2017 and decreased to 13.0% as of LTM Dec’17. So what’s causing the general improvement?
Understanding Microsoft’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 Microsoft’s improving returns?
Net Profit Margin Trends
It appears that the net profit margin of Microsoft has generally been increasing over the last few years. Margins increased from 13.0% to 19.7% in fiscal year 2016, increased to 23.6% in 2017 and decreased to 10.0% as of LTM Dec’17.
Therefore, the company’s increasing margins help explain, at least partially, why ROE is also increasing. Now let’s take a look at Microsoft’s efficiency performance to see if that is also boosting ROE.
Asset Turnover Trends
Unfortunately for shareholders, Microsoft’s asset turnover has decreased each year since 2015. Turnover decreased from 0.54x to 0.46x in fiscal year 2016, decreased to 0.41x in 2017 and decreased again to 0.40x as of LTM Dec’17.
source: data explorer – asset turnover
Therefore, the company’s improving ROE is not as a result of its asset turnover performance which has been steadily declining.
Finally, the DuPont constituents that make up Microsoft’s ROE are shown in the table below. Note that the table also compares Microsoft to a peer group that includes Oracle Corporation(NYSE: ORCL), Vmware, Inc. (NYSE: VMW), International Business Machines Corporation(NYSE: IBM) and Salesforce.com Inc (NYSE: CRM).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Microsoft’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, Microsoft shareholders should not be too excited due to the company’s general improvement in profitability along with deteriorating 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 Microsoft to get a more comprehensive view of the company by looking at:
Valuation Metrics: how much upside do shares of Microsoft have based on the Ben Graham Formula? Take a look at our Ben Graham Formula data explorer which also compares the company’s upside to its peers.
Risk Metrics: what is Microsoft’s Altman Z score? It’s a famous formula used to predict the probability that a firm will go into bankruptcy within two years. View the company’s Altman Z score here.
Efficiency Metrics: how much free cash flow does Microsoft generate as a percentage of total sales? Has it been increasing or decreasing over time? Review the firm’s free cash flow margin 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.