Breaking Down ROE Using the DuPont Formula

by Joe Lan, CFA

Return on equity (ROE) is a commonly used profitability ratio that measures the effectiveness of management in generating earnings for shareholders.

Return on equity measures net income less preferred dividends against total stockholder’s equity. The three primary drivers of ROE are better sales (or turnover), greater margins and higher debt levels, each of which can lead to a higher ROE. Although return on equity is a useful tool, it does not tell you what factors are helping or hurting the company’s performance. The DuPont formula addresses this concern by breaking down ROE and allowing investors to see which characteristics are driving ROE. Analysis of the DuPont formula allows you to determine whether management is gener

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Joe Lan, CFA is a financial analyst at AAII.


Discussion

Robert Ferguson from Pennsylvania posted about 1 year ago:

Unless I'm missing something the formulas here are actually trivial. Basic fraction calculations say (a/b) x (b/c) = (a/c). All the formulas in the article can be reduced to
ROE = (net income)/ equity.

If there is something else here, the author has hidden the salient information.

I would expect better editing or review.


Douglas Elrod from New York posted about 1 year ago:

The fact that the formulas can be "reduced" to the basic ROE relationship just tells you that the math is CONSISTENT.

The interesting thing about the DuPont relationship is that an ROE can be seen to be composed of several causes, compounded together. So, you might find two companies with similar large ROEs, where one accomplishes it simply by high equity multiplier (debt leverage), but the other has higher profit margins. This is decidedly NON-trivial!


Daniel Golden from Pennsylvania posted about 1 year ago:

Everyone needs to be careful in using the Dupont or modified Dupont formulation. When the ratios are multiplied together the only meaning that is left is [net income]/[equity]. The meaning or value of the individual ratios is lost. That is the danger of multiplying a bunch of numbers together.

Any value of the ratios has to be in the ratios themselves and not in the final number that only has value as [net income]/equity.

Dan


Steven Sears from Iowa posted about 1 year ago:

This is a a truly great article for me. I have mostly thought about the various report numbers separately. This has been an enlightenment thinking about how the numbers work together much like a mechanical device. I have a long way to go. This has been a good step.


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