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 generating value for shareholders effectively.
In this article
- Return on Equity
- The DuPont Formula
- Analysis of the DuPont Formula
- Extended DuPont Formula
- Conclusion
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Return on Equity
Return on equity measures the level of income attributed to shareholders against the investment that shareholders put into the firm. In other words, it measures how efficiently a company is able to generate profits using shareholder’s equity, which includes stock offerings and retained earnings.
There are different ways to calculate ROE. The denominator of the equation, total shareholder’s equity, can simply be the shareholder’s equity at the end of the period, which is found on the balance sheet. Alternatively, the figure used can be the average shareholder’s equity, which is calculated by taking the average of the shareholder’s equity for the beginning and the end of the fiscal period. It is generally more accurate to use average shareholder’s equity for the denominator since the ratio compares an income statement item (which lists data over a period of time) to a balance sheet item (which lists financial data for a point in time).
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Discussion
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.
posted 2 months ago by Robert Ferguson from Pennsylvania
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!
posted 2 months ago by Douglas Elrod from New York
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
posted 2 months ago by Daniel Golden from Pennsylvania
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.
posted 2 months ago by Steven Sears from Iowa
