return on equity is one of the few ratios that ignores the price of the
stock so what does return on equity actually tell us well it can tell us a
lot if we look close enough and this is where the DuPont analysis comes in in
the DuPont analysis we break down return on equity this break down helps us see
the impact of profit margins leverage and turnover on shareholder returns
let's look a bit closer the calculation for return on equity often called ROE
for short is simply net income divided by equity so this tells us how much
profit a company generates for each dollar of equity so a return on equity
of 25 percent tells us that for every $1 of equity the company generates 25 cents
in profit but how return on equity is generated can often help add to the
story so essentially the DuPont analysis is a breakdown of this formula to look
closer at how ROE was generated here's an example of an income statement
and a balance sheet so if we simply take net income and divided by the average
equity we see that we get a return on equity of 32% now you may notice that we
simply use net income and we had to use average equity not just equity and
that's because net income is the income earned over the entire year while equity
and the balance sheet as a whole is simply a snapshot at a specific point in
time in this case the end of 2017 so to make the two numbers comparable we
typically use averages on the balance sheet so we add up the starting number
which is the ending number from last year to this year's ending number and we
divide by 2 simple enough now let's start breaking this down if we take net
income and divide it by revenue we get net profit margin but then we can take
revenue and divided by the average total equity and this gives us our equity
turnover net profit margin tells us what percentage of revenue is converted to
profit equity turnover measures how much revenue the equity is able to generate
over the course of the year but we can go further we break equity turnover down
by adding average total assets so now we have net profit margin asset turnover
and a leverage ratio this allows us to see how the equity turnover was created
and how it contributed to over return on equity asset turnover helps us
examine how effectively management uses the assets to generate revenue this
leverage ratio shows us how much the company borrows or how leveraged they
are because don't forget the basic formula of the balance sheet its assets
equals liabilities plus equity so if there were no liabilities
well then assets and equity would be the same and our leverage ratio would be one
so the more debt the company has the higher this ratio will be now if we
stopped right here this formula was the original version of the du Pont equation
but it was realized that the net profit margin formula can be further
deconstructed to give us even more information instead of going right from
net income to revenue we could break this into tax burden which shows us the
effects of taxes on profit interest burden which shows us the effects of
interest expenses and finally operating margin which shows us the percentage of
profit from operating the business now if we simply multiply these numbers we
end up with the exact same 32% we calculated to start with now we could do
the same DuPont decomposition to a competitor in the same industry to
analyze not just how return on equity stacks up but why they're different we
could also compare a company to its own history why has ROE changed since we
had the last few years in numbers here let's take a look at the changes so in
2015 ROE was a hundred and one percent in 2016 it fell to 73% in the
calculation we already saw in 2017 it was just 32 percent when we look closer
we can see of the tax burden fell which is negative for ROE all these
percentages here the closer they are to a hundred percent the less impact they
have on ROE so the 50% we can see that taxes took a huge chunk out of
earnings before taxes then interest burn got slightly worse
each year by the looks of it it seems that EBIT was falling faster than
interest expenses were falling then we have operating margin and that
got worse as well suggesting a less efficient business now we can also see
that asset turnover is falling which tells us that a hundred dollars in
assets let's say in 2015 produce seventy two dollars in revenue
now it's only producing sixty five dollars in revenue
generally higher financial leverage leads to a higher return on equity and
this makes sense because if a company had a ton of debt well this would lead
to a smaller equity which in turn would create a higher return on equity so we
usually want to be careful if we see return on equity improving but then we
noticed that it is due to an increase in financial leverage this can be a red
flag about the company so that's an example of the DuPont equation and how
we can use a DuPont equation to determine what is happening to return on
equity if you have any questions about the world of investing any suggestions
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