millennialinvest.com http://ww w .millenni alinvest.com/ blog/2014/7/7 /what-drives-the-re turn-the-market-earns -on-equity Patrick O'Shaughnessy What Drives the Market's Return on Equity? Earning a high return on equity is one of the primary reasons to do business. Managers of (and investors in) companies want to earn the highest return on their equity as possible, and sustain this high rate of return over as long a period as possible. Some sectors of the market, like consumer staples, have had remarkably high returns over the very long-term, while others, like automobiles, have had extremely cyclically returns on equity . The market as a whole is cyclical too, sitting somewhere between these two extremes over the past fifty years. In this piece I’ll break the market-level return on equity into its components (pro fit margin, asset turnover, and financial leverage) and try to identify where we are in the current cycle. Three Components High return on equity is almost always a good thing, but the source of return can come from three different areas. 1. Profit Margin —calculated as net income (earnings) divided by sales (revenue), this simple measure shows how much of a company’s (or the market’s) sales are converted to bottom line earnings after all ordinary orextraordinary expenses. Higher margin = higher return on equity. 2. Asset Turnover—calculated as sales divided by average assets, this measure shows how “productive” assets are. Imagine two companies that both use similar machines (which each cost $10,000) to make widgets. Company A uses its machine to produce $10,000 in widget sales per year while company B uses its machine to
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Earning a high return on equity is one of the primary reasons to do business. Managers of (and investors in)
companies want to earn the highest return on their equity as possible, and sustain this high rate of return over aslong a period as possible. Some sectors of the market, like consumer staples, have had remarkably high returns
over the very long-term, while others, like automobiles, have had extremely cyclically returns on equity.
The market as a whole is cyclical too, sitting somewhere between these two extremes over the past fifty years. In
this piece I’ll break the market-level return on equity into its components (profit margin, asset turnover, and
financial leverage) and try to identify where we are in the current cycle.
Three Components
High return on equity is almost always a good thing, but the source of return can come from three different areas.
1. Profit Margin—calculated as net income (earnings) divided by sales (revenue), this simple measure shows
how much of a company’s (or the market’s) sales are converted to bottom line earnings after all ordinary or
extraordinary expenses. Higher margin = higher return on equity.
2. Asset Turnover —calculated as sales divided by average assets, this measure shows how “productive”
assets are. Imagine two companies that both use similar machines (which each cost $10,000) to make widgets.
Company A uses its machine to produce $10,000 in widget sales per year while company B uses its machine to