Question 7.16: Five-Way Decomposition of ROE An analyst examining Royal Dut......
Five-Way Decomposition of ROE
An analyst examining Royal Dutch Shell PLC (Amsterdam and London SEs: RDSA) wishes to understand the factors driving the trend in ROE over a recent four-year period. The analyst obtains and calculates the following data from Shell’s annual reports: (Table 1)
What might the analyst conclude?
| 2009 | 2008 | 2007 | 2006 | |
| ROE | 9.53% | 20.78% | 26.50% | 24.72% |
| Tax burden | 60.50% | 52.10% | 63.12% | 58.96% |
| Interest burden | 97.49% | 97.73% | 97.86% | 97.49% |
| EBIT margin^\text{a} | 7.56% | 11.04% | 13.98% | 13.98% |
| Asset turnover | 0.99 | 1.71 | 1.47 | 1.44 |
| Leverage | 2.15 | 2.17 | 2.10 | 2.14 |
| (Table 1) | ||||
^\text{a}Shell’s income statement does not present a separate subtotal for operating income. EBIT was calculated as Earnings before taxes plus interest.
The tax burden measure has varied, with no obvious trend. In the most recent year, 2009, taxes declined as a percentage of pretax profit. (Because the tax burden reflects the relation of after-tax profits to pretax profits, the increase from 52.10 percent in 2008 to 60.50 percent in 2009 indicates that taxes declined as a percentage of pretax profits.) This decline in average tax rates could be a result of lower tax rates from new legislation or revenue in a lower tax jurisdiction. The interest burden has remained fairly constant over the four-year period indicating that the company maintains a fairly constant capital structure. Operating margin (EBIT margin) declined over the period, indicating the company’s operations were less profitable. This decline is generally consistent with declines in oil prices in 2009 and declines in refining industry gross margins in 2008 and 2009. The company’s efficiency (asset turnover) decreased in 2009. The company’s leverage remained constant, consistent with the constant interest burden. Overall, the trend in ROE (declining substantially over the recent years) resulted from decreases in operating profits and a lower asset turnover. Additional research on the causes of these changes is required in order to develop expectations about the company’s future performance.