One Metric Makes Village Super Market, Inc. (VLGEA) Special: The Kroger Co. (KR), Kansas City Southern (KSU)

ROA x Financial Leverage = ROE

“Unlevered” is the key word in describing Village Super Market, Inc. (NASDAQ:VLGEA)’s superior return. Village Super Market is a better business than Kansas City Southern (NYSE:KSU), but that does not mean it earns a higher return for equity holders. To demonstrate the effect of financial leverage on shareholder value, let’s look at one of Village Super Market’s competitors.

The Kroger Co. (NYSE:KR) has some of the best growth prospects in the industry due to its stable competitive position. Even with that said, Kroger’s profit margin and asset turnover are not good enough to beat Village Super Market, Inc. (NASDAQ:VLGEA). Over the last 10 years, Kroger averaged an EBIT margin of 3.1% vs 3.8% for Village and an asset turnover of 1.99x vs 3.06x for Village. 3.1% times 1.99 = 6.2% pre-tax, pre-interest ROA vs 11.42% for Village.

However, The Kroger Co. (NYSE:KR) routinely earns a much higher return on equity than Village due to financial leverage. Village is underleveraged — meaning it could take on more debt without unreasonably increasing the company’s risk.

Final Thoughts

Village Super Market, Inc. (NASDAQ:VLGEA) is a better business than both Kansas City Southern (NYSE:KSU) and The Kroger Co. (NYSE:KR). It earns more money for each dollar of assets in the business than the other two companies. However, Kroger and Kansas City Southern are doing more to maximize shareholder value by leveraging their assets with debt. As a result, Kroger earns a higher ROE than Village and Kansas City Southern earns a higher ROE than it otherwise would have.

Nevertheless, Village’s superior asset turnover over an extended period of time proves that it is a better business than the other two companies. If you strip away the financial leverage, you would always buy Village holding all else equal. Village’s lower debt load also affords investors more protection during a downturn — The Kroger Co. (NYSE:KR) did not fare nearly as well as Village during the recent recession.

Asset turnover is not the be-all end-all metric to look at. But it does offer insights into the relative superiority of one business over another — a valuable tool for investors looking to scoop up quality at a bargain price.

The article One Metric Makes This Company Special originally appeared on Fool.com and is written by Ted Cooper.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.