Breaking Down ROE Using the DuPont Formula
by Joe Lan, CFA
Return on equityis 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
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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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