When we looked at the historical book values of FedEx (FDX) and UPS, it was clear that UPS has always traded at a significant premium to its book value as compared to FDX. To understand why, one only has to compare the relative returns on equity* for the two companies: UPS 16.6%, FDX 11.6%. But how UPS manages to generate a higher return on equity may come as a surprise to many.
To demonstrate how UPS generates the higher return on equity (ROE), it's useful to examine the following equation: ROE = Net Income / Equity
ROE can be further broken down into (Net Income / Assets) * (Assets / Equity).
In other words, we can break down a company's return on equity as a combination of its return on assets (Net Income / Assets) and its use of leverage (Assets / Equity).
But for both FDX and UPS, return on assets sits at 6.3%! This means the major difference between the ROE for these two companies comes from differing uses of leverage. Indeed, the debt to capital ratio for FDX sits at just 13% compared to 44% for UPS. This means UPS hasn't generated its superior returns through better operations, but rather by using cheaper capital (debt) while taking more risk as a result.
Should UPS pay down its debt so that its risk level isn't so high, or should FDX take advantage of cheaper capital in order to generate more returns for shareholders? We'll explore these questions in a future post.
*To smooth out fluctations, ratios in this article were taken using the average of the last two fiscal years of each company.