Deere & Company (NYSE: DE) generated an above average return on equity of 17.7% over the past twelve months, while the Industrials sector returned 10.6%. Even though Deere’s performance is impressive relative to its peers, it’s useful to understand what’s really driving the company’s healthy ROE and how it’s trending. Understanding these components may change your views on Deere and its future prospects.
Deere’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.
Deere’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
The return on equity of Deere has generally been declining over the last few years. ROE decreased from 24.5% to 22.9% in fiscal year 2016, increased to 26.8% in 2017 and decreased to 17.7% as of LTM Jan’18. So what’s causing the general decline?
What’s Driving Deere’s Declining 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 Deere’s returns.
Deere’s Net Profit Margin
The net profit margin of Deere has generally been declining over the last few years. Margins decreased from 6.7% to 5.7% in fiscal year 2016, increased to 7.3% in 2017 and decreased to 4.6% as of LTM Jan’18.
Therefore, the company’s decreasing margins help explain, at least partially, why ROE is also decreasing. Now let’s take a look at Deere’s efficiency performance.
Deere’s Asset Turnover
It appears that asset turnover of Deere has generally been increasing over the last few years. Turnover decreased from 0.48x to 0.46x in fiscal year 2016, increased to 0.48x in 2017 and increased again to 0.51x as of LTM Jan’18.
source: data explorer – asset turnover
As a result, the company’s declining ROE is not due to its asset turnover performance which has generally been increasing.
Finally, the DuPont constituents that make up Deere’s ROE are shown in the table below. Note that the table also compares Deere to a peer group that includes CNH Industrial N.V. (NYSE: CNHI), AGCO Corporation (NYSE: AGCO), Caterpillar, Inc. (NYSE: CAT) and Toro Company (The) (NYSE: TTC).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Deere’s general decline in return on equity is the result of a worsening net profit margin, an improving asset turnover ratio and declining leverage. Therefore when looking at the core operations of the business, Deere shareholders do not need to be too concerned due to the company’s general decline in profitability along with a general improvement in operational efficiency and declining 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 Deere 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.