DuPont Equation and Its Implication

In the article “Calculate Profit Margin”, we mentioned that even though we prefer a company with high profit margin, it does not necessary mean this company has high return on equity. To the end, return on equity (ROE) is still one of the most important ratios to influence investment decisions. However, there is a relationship between ROE and profit margin. In this article, we are going to derive the relationship between ROE and profit margin (DuPont Equation) and explain how to use it to make investment decision.
 

ROE Decomposition

Return on Equity (ROE) is a ratio to measure the return on the shareholder’s equity. That’s the reason why it influences investment decision so much. The formula of ROE is simple:
ROE = Net Income / Average Shareholder’s Equity
Note here we use average shareholder’s equity instead of shareholder’s equity for calculation. It is because shareholder’s equity never constant during the fiscal period. It is better to use averaged shareholder’s equity during the fiscal period than the one at the end of fiscal period.
We can make first level decomposition of the above formula:
ROE = (Net Income / Average Total Assets) * (Average Total Assets / Average Shareholder’s Equity)
In the article “Calculate Financial Leverage”, we showed how to calculate financial leverage from debt-equity ratio. Because a company’s total assets = debt + equity,
=> Average Total Assets / Average Shareholder’s Equity = Financial Leverage
=> ROE = Return on Assets * Financial Leverage
We can further decompose return on assets (ROA):
ROA = Net Income / Average Total Assets
= (Net Income / Revenue) * (Revenue/Averaged Total Assets)
While Net Income / Revenue is profit margin and Revenue / Averaged Total Assets is
Asset turnover ratio
Now we derived the final format of DuPont equation:
ROE = ROA * Financial Leverage
= (Net Income/Revenue) * (Revenue/Averaged Total Assets) * (Averaged Total Assets/Averaged Shareholder’s Equity)
=> ROE = Profit Margin * Asset Turnover Ratio * Financial Leverage
 

Implication

From the formula above, it implies that we can always breakdown a company’s ROE into three elements: profit margin, asset turnover ratio, and financial leverage. By breaking down a company’s ROE into these three elements allows us to further investigate the main driver of a company’s ROE.
 

High Profit Margin as ROE Driver

Some industries tend to have high profit margin as their ROE driver. That means they tend to sell less units of product but each unit sold need to have high profit margin to have competitive edge
 

High Asset Turnover Ratio as ROE Driver

Some industries tend to have high asset turnover ratio as their ROE driver. That means they try to sell as many goods as possible in order to maintain proper ROE. Sudden drop of sales volume might hurt their ROE
 

High Financial Leverage as ROE Driver

Some industries tend to have high financial leverage as their ROE driver. That means they try to generate profit by borrowing other people’s money. However, high financial leverage accompanies high financial risk.