Tech Is the New Macro: Impacting All Three Components of Return on Equity
- Technology is positive for all three return on equity (ROE) components — profit margins, asset utilization, and leverage.
- Profit margins have soared over the last two decades, reflecting lower labor costs and the evolution to a more capital-light balance sheet.
- Asset utilization also improves with technology, as you have higher sales per dollar of assets employed in the business (e.g., plant, equipment, and inventories).
- Regarding leverage, if you don’t need as many assets to run a business, you have the ability to return excess capital to shareholders via cash dividends, share repurchases, or debt reduction. Thus the payout ratio can rise.
- Tech platforms and their network effects have resulted in a winner-takes-all market, with “wide digital moats” potentially protecting the over-sized returns of these new global champions.
- In our view, disruptive innovation will affect all economic sectors, not just information technology. As a result, we believe it is ever more important to favor companies with a demonstrated ability to produce free cash flow and allocate that cash flow wisely between return of capital options and reinvestment/acquisition opportunities.
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Capex (Capital expenditure): Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment.
DuPont analysis breaks apart ROE to gain a better understanding of where movements in ROE are coming from. Dupont’s equation breaks up ROE into three components: 1) Operating efficiency – as measured by profit margin, 2) Asset use efficiency – as measured by total asset turnover, and 3) Financial leverage – as measured by the equity multiplier.
Smoothing is the use of accounting techniques to level out fluctuations from one period to the next.
Wide digital moat: A sustainable competitive advantage created by the use of technology that a business possesses that makes it difficult for rivals to wear down its market share and profit.
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