Breakdown of Return on Equity (ROE)
(DuPont Method of Analysis)

Glossary

Return on Equity - A ratio that measures the profitability of the company.  It is calculated by dividing a company's Earnings After Taxes (EAT or net income) by the company's common equity.

DuPont Method - A method of analysis that breaks down return on equity into the sources of that profitability.  The method is named for the company that originally conducted the analysis.

The Sources of A Company's Profits

It is possible to break down the return on equity (ROE) ratio into several smaller parts.  This is useful because there are five ways, and only five ways, for a company to increase its profits.  Four of these ways are captured in the following equation: 

This breakdown shows the sources of a company's profits.  A company can:

1. improve its profit margin by doing a better job of controlling costs and pricing its products appropriately

2. increase its turnover through the use of effective advertising, branding, sales promotions, and training of its sales force.

3. increases leverage by utilizing bit more to finance the company.

4. reduce the amount of taxes paid as a result of effective tax planning (although this is generally the least important of the four factors).

(There is a fifth source of a company's profits - cheaper leverage - but the movement of interest rates in the economy is not under the control of any individual company.  Therefore the four sources shown above are the areas that a company’s management can control.)

If we take a closer look that the above equation, we can see that two of the four factors (margin and turnover) are controlled by the operating managers and that two (leverage and tax effect) are controlled by the financial managers.  For this reason, the first two factors are often referred to as operating factors and the last two are referred to as financial factors.

Why is this important?  It's simply because most investors would rather see a company's profits originate from the operating factors rather than the financial factors.  In other words, which would you rather invest in?  A company that is

1. performing very well in the operations area (purchasing, production, working etc.) and which is conservatively financed (i.e., has a low level of debt), or

2. performing very poorly in the operations area and is very aggressively financed (i.e., has a high level of debt)?

Most of us would rather invest in the first of the two choices.  After all, increasing a company's leverage generally increases its risk.  So our choice is: (1) to invest in a company that managed very well and which has low risk in its financing, or (2) to invest in a company that is managed very poorly and which has high risk in its financial policy.  The choice is obvious.

All of this is important because a company's managers will often attempt to pump up a weak operational profit by adding large amounts of leverage to the company.  In other words, a weak operating result is enhanced through the use of high amounts of leverage.  If we simply calculate a company’s ROE and stop there, we may be easily misled unless we examine the source of that company's profits.

For example, consider the comparison of two large retail firms in the U.S.  At the current time, both of these companies have approximately the same ROE (between 20% and 21%).  The implication is that both of these companies are equally profitable and, therefore, equally attractive. But when we examine the source of each’s profitability, we find that (1) one company has outstanding operating factors (margin and turnover) and low debt and (2) that the other company performs very poorly in its operations but enhances this low level of profitability through the use of a high amount of debt.  Obviously, we would prefer to invest in the first.  But we would never know this if we focused solely on the ROE and did not conduct the breakdown of ROE into the sources of the company's profits.