Return on Equity - The DuPont Model
Analyzing the Three Components of Return on Equity
As you learned in the investing lessons, return on equity (ROE) is one
of the most important indicators of a firms profitability and
potential growth. Companies that boast a high return on equity with
little or no debt are able to grow without large capital expenditures,
allowing the owners of the business to withdrawal cash and reinvest it
elsewhere. Many investors fail to realize, however, that two companies
can have the same return on equity, yet one can be a much better
business.
For that reason, according to CFO Magazine, a finance executive at
E.I. du Pont de Nemours and Co., of Wilmington, Delaware, created the
DuPont system of financial analysis in 1919. That system is used
around the world today and will serve as the basis of our examination
of components that make up return on equity.
Composition of Return on Equity using the DuPont Model
There are three components in the calculation of return on equity
using the traditional DuPont model; the net profit margin, asset
turnover, and the equity multiplier.By examining each input
individually, we can discover the sources of a company's return on
equity and compare it to its competitors.
Net Profit Margin
The net profit margin is simply the after-tax profit a company
generated for each dollar of revenue. Net profit margins vary across
industries, making it important to compare a potential investment
against its competitors. Although the general rule-of-thumb is that a
higher net profit margin is preferable, it is not uncommon for
management to purposely lower the net profit margin in a bid to
attract higher sales. This low-cost, high-volume approach has turned
companies such as Wal-Mart and Nebraska Furniture Mart into veritable
behemoths.
There are two ways to calculate net profit margin (for more
information and examples of each, see Analyzing an Income Statement):
1.Net Income / Revenue
2.Net Income + Minority Interest + Tax-Adjusted Interest / Revenue.
Whichever equation you choose, think of the net profit margin as a
safety cushion; the lower the margin, the less room for error. A
business with 1% margins has no room for flawed execution. Small
miscalculations on managements part could lead to tremendous losses
with little or no warning.
Asset Turnover
The asset turnover ratio is a measure of how effectively a company
converts its assets into sales. It is calculated as follows:
Asset Turnover = Revenue / Assets
The asset turnover ratio tends to be inversely related to the net
profit margin; i.e., the higher the net profit margin, the lower the
asset turnover. The result is that the investor can compare companies
using different models (low-profit, high-volume vs. high-profit,
low-volume) and determine which one is the more attractive business.
Equity Multiplier
It is possible for a company with terrible sales and margins to take
on excessive debt and artificially increase its return on equity. The
equity multiplier, a measure of financial leverage, allows the
investor to see what portion of the return on equity is the result of
debt. The equity multiplier is calculated as follows:
Equity Multiplier = Assets / Shareholders Equity.
Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply
multiply the three components (net profit margin, asset turnover, and
equity multiplier.)
Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).
Pepsico
To help you see the numbers in action, Ill walk you through the
calculation of return on equity using figures from Pesicos 2004 annual
report. The key figures Ive taken from the financial statements are
(in millions):
Revenue: $29,261
Net Income: $4,212
Assets: $27,987
Shareholders Equity: $13,572
Plug these numbers into the financial ratio formulas to get our components:
Net Profit Margin: Net Income ($4,212) / Revenue ($29,261) = 0.1439,
or 14.39%Asset Turnover: Revenue ($29,261) / Assets ($27,987) =
1.0455Equity Multiplier: Assets ($27,987) / Shareholders Equity
($13,572) = 2.0621
Finally, we multiply the three components together to calculate the
return on equity:
Return on Equity: (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%
Analyzing Your Results
A 31.02% return on equity is good in any industry. Yet, if you were to
leave out the equity multiplier to see how much Pepsico would earn if
it were completely debt-free, you will see that the ROE drops to
15.04%. In other words, for fiscal year 2004, 15.04% of the return on
equity was due to profit margins and sales, while 15.96% was due to
returns earned on the debt at work in the business. If you found a
company at a comparable valuation with the same return on equity yet a
higher percentage arose from internally-generated sales, it would be
more attractive. Compare Pepsico to Coca-Cola on this basis, for
example, and it becomes clear (especially after adjusted for stock
options) that Coke is the stronger brand.
