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Chapter 1
THE PROBLEM AND ITS BACKGROUND
Introduction
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breaking down the return on equity into a more complex equation to further provide an
in-depth analysis of the return.
Given a wide range of possible investments in different sectors listed in the
Philippines, the components of return on equity plays an important role as to
considering which among those financial opportunities are best to indulge an investors
asset. This research will tackle about the different components of return on equity using
DuPont analysis, namely; profit margin, asset turnover, and financial leverage
extensively across different sectors listed in the Philippine Stock Market.
The Philippine Stock Exchange is one of the oldest stock exchanges in Asia and
the only stock exchange in the Philippines. It currently maintains two trading floors, one
located at the PSE Centre (Tektite), Ortigas Center in Pasig City and the other at its
principal office at the Ayala Tower One in Makati Citys Central Business District. The
PSEs main index is called the PSEi which is composed of a fixed basket of thirty (30)
listed companies. The PSEi measures the relative exchanges in the free float-adjusted
market capitalization of the 30 largest and most active common stocks listed at the
Philippine Stock Exchange. The 30 selected companies were based on a specific set of
public float, liquidity and market capitalization criteria.
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Furthermore, there are six sector-based indices in PSE to dissect the shares
listed according to its main line of operation; Financials, Industrial, Holding Firms,
Services, Mining and Oil and Property.
The Financials sector includes companies whose operations are engaged in
banking, investments, and finance. The Industrial sector includes companies involved in
5 segmented operations; Electricity, Energy, Power, and Water, Food Beverage, and
Tobacco, Construction, Infrastructure, and Allied services, Chemicals, and Diversified
Industrials. The Holding Firms sector includes companies that control or manage partial
or complete interest in another company or other companies. Its purpose is to own
shares of other companies. The Property sector includes companies whose operations
are involved in land and property development. The Services sector includes companies
engaged in Media, Telecommunications, Information Technology, Transportation
services, Hotel and Leisure, Education, and Diversified Services. Lastly, the Mining and
Oil sector includes companies primarily engaged in mining extraction, oil exploration,
extraction and production.
To better understand the above-mentioned sectors in terms of return on equity,
the researchers segmented ROE using DuPont analysis to identify which among the
three components actually drives the financial performance of the company and to
determine which among the three is actually the least contributor. On a larger scale, it
should also reflect the main driver of the sector-based index compared to other indices.
The following data exemplifies the indices of per sector based on month-end data:
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SECTOR-BASED INDICES*
Financi
als
Industr
ial
1,696.2
0
1,703.5
7
1,790.1
2
1,758.3
2
1,864.1
2
1,780.8
6
1,719.5
8
1,724.8
7
1,658.8
4
1,543.1
1
1,531.3
8
1,569.4
7
1,530.7
9
1,550.6
8
11,982.
76
11,918.
92
12,691.
84
12,872.
31
12,831.
97
12,286.
62
11,674.
48
11,554.
57
11,476.
12
10,863.
03
10,651.
65
11,437.
40
11,154.
52
11,031.
22
Holdin Service
g Firms
s
6,299.9
4
6,425.6
8
6,819.6
4
6,770.6
3
7,071.7
4
6,905.4
0
6,745.4
8
6,803.0
7
6,822.7
0
6,381.7
3
6,457.2
2
6,586.4
3
6,502.8
8
6,601.2
6
2,126.1
9
2,121.1
9
2,156.1
1
2,217.3
9
2,100.1
2
2,105.3
8
2,093.6
2
2,063.8
3
2,134.9
5
1,877.4
0
1,656.6
5
1,727.0
8
1,585.6
4
1,530.2
2
Mining
and Oil
Proper
ty
15,815.
26
15,858.
54
15,754.
19
16,321.
35
15,484.
38
14,990.
81
14,131.
12
13,574.
10
11,921.
58
10,582.
25
10,721.
74
11,434.
74
10,738.
29
10,427.
24
2,810.2
5
2,803.5
2
2,992.9
0
3,058.4
3
3,193.1
0
3,108.8
3
3,116.2
0
3,026.1
1
3,104.9
0
2,861.8
6
2,858.0
9
3,023.3
7
2,923.0
2
2,915.6
0
The top five (5) sectors are as follows: Holding Firms (+0.048), Property
(+0.037), Industrial (-0.08), Financial (-0.09), and Services (-0.28). The selection
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process of the top 5 sectors is based on a year change from period 2014 to 2015.In
order to fully understand the main drivers of each sector, the financial performance of
selected top five (5) companies for the calendar year 2015 are taken as samples for the
purpose of this study.
Return on equity is a financial measure of a corporations profitability that reveals
the amount of profit that was generated through business operations given the amount
of money invested by the shareholders. It is a strong measure of how well a companys
management is creating value for its shareholders. Also, it is considered as one of the
most important number in determining the financial performance of a company because
it is a common tool and a benchmark used by the investors in evaluating current and
prospective business investments. The following formula pertains to the computation of
return on equity:
ROE=
Net Income
x 100
Shareholder Equity
Return on equity has three ratio components; Profit margin, Asset turnover, and
Financial leverage. The following depicts the segmented formula for computing return
on equity:
Net Income
Sales
Total Assets
ROE=
x
x
Sales
Total Assets Shareholder Equity
Profit margin is a profitability ratio that measures the percent of profits a company
generate for each peso sales. It reflects the ability of the company to control costs and
make returns possible on every sale. In a given company, individual numbers pertaining
to revenue or expenses are not sufficient enough to indicate the profitability of a
company simply because it does not exemplify the whole picture but the fact that it is
only a portion. It must be noted that an increase in revenue is good as well as
decreases in expenses, but this does not necessarily mean that the profit margin of a
company is improving as well. There may be instances wherein the increase in
expenses far outweighs the increase in revenue or the decrease in revenues is greater
than the decrease in expenses thereby resulting to a lower profit margin. As to the
interest of the management and the investors, the higher the profit margin the better.
The computation for the profit margin is depicted by the formula below:
Figure 3. Formula of Profit Margin
Profit Margin=
N et Income
Sales
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turnover rate exemplifies that a company is highly capital-intensive. The computation for
the asset turnover is shown by the formula below:
Figure 4. Formula of Asset Turnover
Financial Leverage is a measure of how much the company is using equity and
Asset Turnover =
Sales
Total Assets
debt in financing the assets. As a general rule, as the debts of the company increases,
the financial leverage increases. In a standpoint of the management, it is more
Financial Leverage=
Total Assets
Shareholder Equity
The DuPont method of analysis simply broken down the computation of return on
equity into three components; the profit margin which indicates how much profit the
company is able to generate out of its revenues, the asset turnover which depicts how
effectively the management is using its assets to generate revenues, and the financial
leverage which measures how the company is financed for its operations.
Statement of the Problem
This study hoped to determine the controlling component in the ten-year trend of
return on equity using DuPont analysis of the top five (5) performing listed sectors on
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Philippine Stock Exchange for the year 2015. Specifically, the study sought answers to
the following sub problems:
1. What is the socio-economic profile of the top five performing companies under
each determined listed sector in terms of nature of the business, efficiency of
operation, number of employees, asset size, volume of transaction and net
profit?
2. What are the relevant financial ratios of the identified companies as per DuPont
analysis for the years 2005 to 2015?
3. What is the financial-ratio component that mostly influences the trend of return on
equity for each company of respective sectors?
4. Is there a similarity of controlling financial-ratio component of return on equity
across companies under the same sector in the ten-year DuPont analysis?
5. What are the implications of the controlling financial-ratio component of return on
equity to the identity of financial management of each sector in terms of
operation efficiency, asset effectiveness and capital structure?
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2. Calculate the relevant financial ratios of the identified companies as per DuPont
analysis for the years 2005 to 2015.
3. Determine the financial-ratio component that mostly influences the trend of return
on equity for each company of respective sectors.
4. Identify whether there is similarity of controlling financial-ratio component of
return on equity across companies under the same sector in the ten-year DuPont
analysis.
5. Describe the implications of the controlling financial-ratio component of return on
equity to the identity of financial management of each of the top five performing
listed sectors in terms of operation efficiency, asset effectiveness and capital
structure.
Hypothesis
There is no significant similarity of controlling financial-ratio element of return on
equity across companies and such reasonably characterize the respective sectors.
Theoretical Framework
This study uses the DuPont analysis or DuPont identity, a method of
performance measurement that was started by DuPont Corporation in the 1920s. Using
this method, return on equity will be measured and broken down into three financial
ratios: profit margin; asset turnover ratio; and equity multiplier. In addition, assets are to
be valued at their gross book value rather than at net value to produce a higher return
on equity (ROE). Under the DuPont analysis, ROE is affected by three factors:
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operating efficiency (measured by profit margin); asset effectiveness (measured by total
asset turnover ratio); and capital structure or financial leverage (measured by equity
multiplier).
ROE is a closely monitored financial indicator among sensible investors that has
a good telling on how well a companys management creates value for its shareholders.
Basically, it is simply measured by getting the ratio of net income over shareholders
equity. However, such ratio can be deceptive sometimes as it does not take into account
other risks involve in capital structuring (i.e. firms extent of debt financing). That is why,
DuPont analysis is designed to break down ROE into its three financial-ratio
components to help people make better decisions as they determine which of these
components is most accountable for changes in ROE (Pinsent 2014).
Conceptual Framework
Independent Variable
Dependent Variable
DuPont Components of
Return on Equity of the Top
5 Companies
Implications on Financial
Management of the
Listed Sector
Profit Margin
Asset Turnover
Equity Multiplier
Intervening Variable
Socio-economic Profile of the Top
5 performing listed sectors in PSE
Operating
Efficiency
Asset
Effectiveness
Capital Structure
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Figure 6. Research Paradigm of the Study
The study is designed to determine what financial ratio among the three
components in DuPont analysis controls the ROE across companies of different listed
sectors and whether the companies of each listed sector collectively share a similar
controlling financial ratio. The researchers used the cause and effect relationship as
shown in Figure 1 to examine the variables identified. The independent variable of the
study is the controlling financial ratio of ROE using the DuPont analysis for the years
2005 to 2015. This could either be profit margin, asset turnover ratio or equity multiplier.
Such ratios will individually be derived first using the relevant financial figures obtained
from each companys annual financial statements. The dependent variable, on the other
hand, is the characterized industry profile and financial management implied by the
controlling financial ratio of the determined sector. In other words, from the determined
controlling financial ratio for each listed sector, the researchers would characterize the
industry profile in terms of operating efficiency, asset effectiveness, or capital structure.
Significance of the study
From the results of the study, the following are the persons or entities expected
to benefit from this study:
Different sectors in the Philippines.
different sectors in the Philippines with in-depth knowledge about their key
strengths and weaknesses in the components of return on equity using DuPont
method of analysis. This would benefit these sectors in maximizing their
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operations on providing a greater value for their shareholders while addressing
their key weaknesses.
Stakeholders.
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The study includes the determination of the top five performing companies listed
under the top five performing listed sectors on the Philippine Stock Exchange for the
year 2015 in terms of their profitability. Data and information that will be used in the
study includes but not limited to financial statements of each company provided for by
the different financial platforms such as PSe edge, Bloomberg, the individual company's
website, online articles and the like from year 2005 to year 2015.
The study focuses on demonstrating which relevant financial ratios under DuPont
analysis (profit margin, asset turnover, or equity multiplier) drives the top five performing
companies' operation efficiency, asset effectiveness and capital structure and how these
factors characterize their industry profile.
The study also includes determining if there are similarities in the controlling
financial-ratio component of return on equity across companies under the same sector
in the ten-year DuPont analysis.
The hypothesis, there is no significant similarity of controlling financial-ratio
element of return on equity across companies and such reasonably characterize the
respective sectors was based on the assumption that though return on equity is a
closely monitored financial indicator among sensible investors, each company's
management has its own targets, goals and metrics for the company as regards asset
management, profitability and operation efficiency which will not necessarily align to the
movement of the sector to which the company belongs to.
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Definition of Terms