In general, there are three levers that a corporation can pull to boost return on equity – margins can expand, assets can be used more efficiently, or more leverage can be taken on.
Global Market Strategist
Listen to On the Minds of Investors
Our first quarter earnings bulletin discussed how 2021 profits are expected to grow strongly after a sharp decline in 2020. However, we also alluded to the fact that higher taxes, rising wages, and slowing revenues all look set to pressure margins and challenge the ability for earnings to continue growing at such a rapid clip in 2022. This has clear implications for return on equity (ROE), which as shown in the chart below, had begun to decline prior to the COVID-induced downturn last year.
In general, there are three levers that a corporation can pull to boost return on equity – margins can expand, assets can be used more efficiently, or more leverage can be taken on1. With almost 20% of S&P 500 companies reporting, profit margins are tracking nearly 12%, which is just below their all-time high of 12.3%. At the same time, U.S. companies want to avoid returning to peak levels of leverage. Finally, many companies that historically sported high returns on equity thought of themselves as being “asset-lite,” but recent changes in accounting rules have forced operating leases to be capitalized, thereby leading them to appear on the balance sheet and drag on asset turnover.
So, if margins are elevated and more leverage isn’t an attractive option, companies need to think of a way to use assets more efficiently. One solution that is being discussed is the idea of “assets as a service.” If a company can reduce the assets on its balance sheet while maintaining the same level of sales, asset turnover and return on equity would both increase. Recently, this has been rewarded by the market – according to Deutsche Bank, U.S. firms that increased asset turnover over the past five years saw a median share price increase of 87% compared with 69% for companies with a decline in asset turnover2.
Asset-lite technology businesses have been embracing this solution for some time – just think of how many companies pay to use cloud platforms in lieu of having to buy the equipment themselves. This could very well extend to industrial businesses going forward; for example, imagine a regional mining company that no longer requires its own drilling equipment, it simply pays to use somebody else’s as needed. Not only would this approach to managing property, plant & equipment (PP&E) boost return on equity, but there is direct alignment with sustainability initiatives as well. Furthermore, it may even help companies where profits are highly levered to economic activity generate more consistent returns on equity going forward.
1 According to DuPont Analysis, return on equity (ROE) is calculated as the product of net income/sales, sales/assets, and assets/equity.
2 Templeman, Luke. How Assets-as-a-Service can save a balance sheet blow out. Deutsche Bank Research. March 2, 2021.
Return on equity has come under pressure since 2018
S&P 500 return on equity, annual, %
Sources: Standard & Poor's, FactSet, J.P. Morgan Asset Management
Data are as of April 22, 2021.