Return on Equity (ROE) is one of the most important pieces of data that investors and creditors use to evaluate a company’s potential to grow and profitability.
ROE is typically calculated as net income divided by shareholder’s equity.
The company’s net income can be found on the income statement, while shareholder’s equity is found on the balance sheet.
ROE reveals how much profit a company has generated using the cash that shareholder’s have invested in the company. In the 1920s,
DuPont Corporation, one of the world’s largest chemical companies, developed a twist on ROE and breaks it further down in to three components: net profit margin, asset turnover and the equity multiplier.
The DuPont Model is calculated by multiplying all three components as follows:
DuPont Return on Equity = (Net Profit Margin) * (Asset Turnover) * (Equity Multiplier)
Net Profit Margin
The net profit margin is the after tax profit a company generates for each dollar of revenue.
A higher net profit margin is usually preferable as this indicates that the company is able to generate a higher profit per dollar.
Net profit margin is calculated using the income statement as follows:
Net Profit Margin = Net Income / Revenue
The asset turnover ratio is a measure of how effective a company is in converting its assets into sales.
A higher ratio indicates that the company is able to better make use of assets in generating cash from sales.
The ratio is calculated as:
Asset Turnover = Revenue / Assets
The equity multiplier is a tool to analyze what portion of the ROE is a result of debt.
It is possible for a company in terrible position sales wise to artificially increase its ROE by taking large amounts of debt.
A higher ratio indicates that the company is relying for a large part on borrowing money to finance the purchase of assets.
The equity multiplier is calculated as follows:
Equity Multiplier = Assets / Shareholder’s Equity.
Example of DuPont Model
Using data collected from Google’s investor relations site (investor.google.com) we are able to gather the following necessary information (in thousands of dollars) for Google’s year-end data 2010:
Total Revenue: $29,321,000
Net Income: $8,505,000
Total Assets: $57,851,000
Shareholder’s Equity: $46,241,000
Net Profit Margin: Net Income ($8,505,000) ÷ Revenue ($29,321,000) = 0.29
Asset Turnover: Revenue ($29,321,000) ÷ Assets ($57,851,000) = 0.507
Equity Multiplier: Assets ($57,851,000) ÷ Shareholder’s Equity ($46,241,000) = 1.251
Finally, The DuPont Model is calculated as [0.29*0.507*1.251] = 0.2068, or 20.68%
Results of DuPont Example
A 20.68% ROE is a good indication of Google’s ability to generate profit.
Stock analysts can use the DuPont Model to make a side by side comparison of two companies in a similar industry with a similar ROE.
Breaking down ROE in to three categories is especially useful in this situation.
If we were to calculate the ROE of Google without the equity multiplier, we would see how much they have earned if it was completely debt free.
In this case, the ROE would be = 0.29*0.507=0.147 or 14.7%.
This indicated that in the year 2010, 14.7% of the ROE was generated from sales, while 5.98% was due to returns earned as a result of borrowing money to finance activities.
When evaluating two companies, the more favorable of the two would obviously be the company with a higher percentage of internally-generated sales.