Morgan Stanley (NYSE: MS) beat the Financials sector by 0.5% as it relates to ROE, producing a fairly healthy 8.9% compared to the sector’s 8.4%. But what is more interesting is whether Morgan Stanley will continue to achieve above average returns moving forward. The DuPont analysis is a useful tool that may help us determine this. In my analysis below, I’ll use the DuPont model to reveal what’s really driving the company’s healthy ROE.
Morgan Stanley’s ROE Trends
Return on equity or ROE represents the percentage return a company generates on the money shareholders have invested.
ROE = Net Income To Common / Average Total Common Equity
In general, 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 impacted by management’s financing decisions such as the deployment of leverage.
Morgan Stanley’s recent ROE trends are illustrated in the chart below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Morgan Stanley has generally been increasing over the last few years. ROE decreased from 8.4% to 8.0% in fiscal year 2016, increased to 8.0% in 2017 and increased again to 8.9% as of LTM Mar’18. So what’s causing the general improvement?
What’s Causing Morgan Stanley’s Improving Return On Equity
A less used approach although being much more intuitive, the DuPont formula is another way to calculate a company’s ROE. It is defined as:
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 causing Morgan Stanley’s improving returns.
Morgan Stanley’s Net Profit Margin Trends
The net profit margin of Morgan Stanley has generally been declining over the last few years. Margins decreased from 16.1% to 15.9% in fiscal year 2016, decreased to 14.7% in 2017 and increased to 16.1% as of LTM Mar’18.
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?
Morgan Stanley’s Asset Turnover Trends
It appears that asset turnover of Morgan Stanley has generally been increasing over the last few years. Turnover decreased from 0.04x to 0.04x in fiscal year 2016, increased to 0.05x in 2017 and increased again to 0.05x 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 Morgan Stanley’s ROE are shown in the table below. Note that the table also compares Morgan Stanley to a peer group that includes Goldman Sachs Group, Inc. (The) (NYSE: GS), Citigroup Inc. (NYSE: C), The Charles Schwab Corporation (NYSE: SCHW) and Bank of America Corporation (NYSE: BAC).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Morgan Stanley’s general improvement in return on equity is the result of a worsening net profit margin, an improving asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Morgan Stanley shareholders may need to start worrying due to the company’s general decline 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 Morgan Stanley 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.