The return on equity (ROE) is an extremely useful metric that measures how well the management at United Parcel Service, Inc. (NYSE: UPS) is investing shareholders' money and the extent to which it is creating or destroying value.
UPS: A Historical Perspective
A commonly accepted ROE calculation is net income divided by average shareholder equity. The latter is beginning equity plus ending equity, divided by 2.
In 2010, the company's ROE was 42.4%. Despite its lower net income, it grew to 70.1% in 2014. This was due to shareholder equity falling, which has been caused partly by UPS buying back shares and raising its dividend. However, there were also other factors that lowered equity.
One way to analyze ROE is to look at the individual components. The DuPont analysis method breaks it down into three parts: net profit margin times asset turnover times the equity multiplier. The first two terms measure operating and asset usage efficiency while the last term is a measure of leverage. ROE can be increased merely by taking on more debt.
Comparing 2014 to 2010, the net profit margin fell to 5.2% from 6.7%, but the asset turnover rose to 1.6 times from 1.5 times. However, the biggest change was in the equity multiplier, which rose about four times to 16. This shows the improvement came about from an increase in leverage, which is worth keeping an eye on going forward.
It is also useful to compare UPS's ROE to its cost of equity. While it is difficult to measure, one way to do so is through the capital asset pricing model (CAPM).This formula is the risk-free rate plus the difference between the return of the market and the aforementioned rate multiplied by the beta of the stock. Using this formula results in a cost of equity of 6% for UPS, well below its ROE. This assumes a 6% return on the stock market, a 10-year Treasury rate of 2% and its historical beta of 1.02. However, this figure should be used with caution.
FedEx Corporation is an appropriate company to compare with UPS. A package delivery company, it is in the same business as UPS. It also generates a similar amount of annual revenue.
FedEx's fiscal year ends on ends May 31. Although it has been volatile, FedEx's ROE fell from 8.9% in fiscal 2011 to 6.9% in fiscal 2015. This is far below UPS's ROE.
It is difficult to find another competitor, but investors can broaden the criteria. Boeing Company is a global company with comparable revenue and market capitalization. Its ROE has declined from about 135% to a still very respectable 46.3%.
The past is useful, but it is not necessarily a predictor of future performance. Still, the high ROE means management has a track record. There is not much direct competition, but UPS is up against freight forwarders, air couriers and the postal service in the United States and other countries, among other companies. The company's profits are also cyclical and dependent on the economy.
In the last decade, UPS has expanded beyond package delivery. It is now a leader is logistics and distribution. However, FedEx also offers this service.
The company hopes to benefit from the expansion of global trade, growth in emerging market economies, outsourcing of logistics, and consumer's increased use of e-commerce to order goods.
There are near-term headwinds, however, This includes a challenging worldwide economic outlook. China's economy has slowed; its gross domestic product (GDP) has slowed to below 7% in the third quarter of 2015. It was above that level for the prior three years. This has impacted Asia's economy and its imports and exports. Additionally, Europe's GDP has weakened in certain areas, particularly Germany. Poland and the United Kingdom.