Last week I noted that blood product company CSL Limited (ASX: CSL) was building up a steady history of monster returns on equity (roe).
At 42% these returns are far above the 6% industry average hinting at a company with a strong, sustainable competitive advantage. But where is the high return coming from?
Breaking down return on equity
To see where CSL's huge 42% ROE comes from, we can break it out into three components using a method called DuPont analysis:
- Net profit margin (Net Income ÷ Revenue) 0.22
- Asset Turnover (Revenue ÷ Assets) 0.73
- Equity Multiplier (Assets ÷ Shareholders' Equity) 2.64
- Return on equity = (0.22) x (0.73) x (2.64) = 42%
Even by healthcare standards CSL's 42% ROE is impressive, with Cochlear Limited (ASX: COH) being one of the few companies to come close at 40%.
But when we break it down we can see that the big driver of the returns is in fact CSL's use of debt to fund assets; the high equity multiplier. Without this, if CSL didn't leverage its assets with borrowed money, ROE would only be 16%.
Why does CSL use debt, rather than fund growth from its strong cash flows? With borrowing costs so low it makes sense to use debt to fund moderate growth if the company knows it can generate new income above it's average cost of capital to pay it back.
CSL has strong cash flows to service its interest payments, but if a comparable investment had a higher unleveraged return, we may prefer to buy it.
Foolish takeaway
To me, CSL is to healthcare what Johnson & Johnson is to consumer products, or what Nestlé is to snack foods; a well-structured staple producer with low cyclical volatility and strong margins and volumes.
It's a company I would still love to own, and I will certainly be watching for any weakness in share price.
