Adobe Systems Incorporated’s (NASDAQ: ADBE) most recent return on equity was an outstanding 23.2% in comparison to the Information Technology sector which returned 2.9%. Though Adobe’s performance over the past twelve months is highly impressive, it’s useful to understand how the company achieved its strong ROE. Was it a result of profit margins, operating efficiency or maybe even leverage? Knowing these components may change your views on Adobe and its future prospects.
ROE Trends Of Adobe
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It is calculated as follows:
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. But it is important to note that ROE can be impacted by management’s financing decisions such as the deployment of leverage.
The return on equity of Adobe is shown below.
source: finbox.io data explorer – ROE
A promising sign for shareholders, Adobe’s return on equity has increased each year since 2015. ROE increased from 9.1% to 16.2% in fiscal year 2016, increased to 21.3% in 2017 and increased again to 23.2% as of LTM Feb’18. So what’s causing the steady improvement?
Adobe’s Improving ROE Trends
In addition to the formula previously discussed, there’s actually another way to calculate ROE. It’s often called the DuPont formula and is as follows:
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 let’s take a closer look at the drivers behind Adobe’s returns.
Net Profit Margin
A promising sign for shareholders, Adobe’s net profit margin has increased each year since 2015. Margins increased from 13.1% to 20.0% in fiscal year 2016, increased to 23.2% in 2017 and increased again to 24.4% as of LTM Feb’18.
As a result, the company’s improving margins help explain, at least partially, why ROE is also improving. Now let’s take a look at Adobe’s efficiency performance.
A promising sign for shareholders, Adobe’s asset turnover has increased each year since 2015. Turnover increased from 0.43x to 0.48x in fiscal year 2016, increased to 0.54x in 2017 and increased again to 0.55x as of LTM Feb’18.
source: data explorer – asset turnover
As a result, the company’s improving asset turnover ratio helps explain, at least in part, why ROE is also improving.
Finally, the DuPont constituents that make up Adobe’s ROE are shown in the table below. Note that the table also compares Adobe to a peer group that includes Salesforce.com Inc (NYSE: CRM), Oracle Corporation (NYSE: ORCL), Activision Blizzard, Inc (NASDAQ: ATVI) and Fair Isaac Corporation (NYSE: FICO).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Adobe’s upswing in return on equity is the result of steadily improving net profit margin, an improving asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Adobe shareholders have reason to be excited due to the company’s steady improvement profitability along with a steady 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. If you have not done so already, I highly recommend that you complete your research on Adobe by taking a look at the following:
Valuation Metrics: what is Adobe’s EBITDA less CapEx multiple and how does it compare to its peers? This is a helpful multiple to analyze when comparing capital intensive businesses. View the company’s EBITDA less CapEx multiple here.
Risk Metrics: what is Adobe’s asset efficiency? This ratio measures the amount of cash flow that a company generates from its assets. View the company’s asset efficiency here.
Efficiency Metrics: is management becoming more or less efficient in creating value for the firm? Find out by analyzing the company’s return on invested capital ratio 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.