Caterpillar Inc (NYSE: CAT) generated an above average return on equity of 15.4% over the past twelve months, while the Industrials sector returned 10.6%. Even though Caterpillar’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 Caterpillar and its future prospects.
Caterpillar’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.
Caterpillar’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Caterpillar has generally been increasing over the last few years. ROE decreased from 15.8% to -0.5% in fiscal year 2016, increased to 5.6% in 2017 and increased again to 15.4% as of LTM Mar’18. So what’s causing the general improvement?
What’s Driving Caterpillar’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 Caterpillar’s returns.
Caterpillar’s Net Profit Margin
It appears that the net profit margin of Caterpillar has generally been increasing over the last few years. Margins decreased from 5.3% to -0.2% in fiscal year 2016, increased to 1.7% in 2017 and increased again to 4.6% as of LTM Mar’18.
Therefore, the company’s increasing margins help explain, at least partially, why ROE is also increasing. Now let’s take a look at Caterpillar’s efficiency performance to see if that is also boosting ROE.
Caterpillar’s Asset Turnover
It appears that asset turnover of Caterpillar has generally been increasing over the last few years. Turnover decreased from 0.58x to 0.50x in fiscal year 2016, increased to 0.60x in 2017 and increased again to 0.62x as of LTM Mar’18.
source: data explorer – asset turnover
Therefore, the company’s increasing asset turnover ratio helps explain, at least in part, why ROE is also increasing.
Finally, the DuPont constituents that make up Caterpillar’s ROE are shown in the table below. Note that the table also compares Caterpillar to a peer group that includes Deere & Company(NYSE: DE), Cummins Inc. (NYSE: CMI), Terex Corporation (NYSE: TEX) and CNH Industrial N.V. (NYSE: CNHI).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Caterpillar’s general improvement in return on equity is the result of an improving net profit margin, an improving asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Caterpillar shareholders have reason to be excited due to the company’s general improvement in profitability along with a general improvement 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 Caterpillar 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.