From Joshua Kennon,
Your Guide to Investing for Beginners.
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As you learned in the investing lessons, return on equity (ROE) is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdrawal cash and reinvest it elsewhere. Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a much better business.

For that reason, according to CFO Magazine, a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of financial analysis in 1919. That system is used around the world today and will serve as the basis of our examination of components that make up return on equity.

Composition of Return on Equity using the DuPont Model

There are three components in the calculation of return on equity using the traditional DuPont model; the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, we can discover the sources of a company's return on equity and compare it to its competitors.

Net Profit Margin

The net profit margin is simply the after-tax profit a company generated for each dollar of revenue. Net profit margins vary across industries, making it important to compare a potential investment against its competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales. This low-cost, high-volume approach has turned companies such as Wal-Mart and Nebraska Furniture Mart into veritable behemoths.

There are two ways to calculate net profit margin (for more information and examples of each, see Analyzing an Income Statement):

1. Net Income ÷ Revenue
2. Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue.

Whichever equation you choose, think of the net profit margin as a safety cushion; the lower the margin, the less room for error. A business with 1% margins has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning.

Asset Turnover

The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:

• Asset Turnover = Revenue ÷ Assets

The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.

Equity Multiplier

It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:

• Equity Multiplier = Assets ÷ Shareholders’ Equity.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)

• Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).

Pepsico

To help you see the numbers in action, I’ll walk you through the calculation of return on equity using figures from Pesico’s 2004 annual report. The key figures I’ve taken from the financial statements are (in millions):

• Revenue: $29,261
• Net Income: $4,212
• Assets: $27,987
• Shareholders’ Equity: $13,572

Plug these numbers into the financial ratio formulas to get our components:

Net Profit Margin: Net Income ($4,212) ÷ Revenue ($29,261) = 0.1439, or 14.39%
Asset Turnover: Revenue ($29,261) ÷ Assets ($27,987) = 1.0455
Equity Multiplier: Assets ($27,987) ÷ Shareholders’ Equity ($13,572) = 2.0621

Finally, we multiply the three components together to calculate the return on equity:

Return on Equity: (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%

Analyzing Your Results

A 31.02% return on equity is good in any industry. Yet, if you were to leave out the equity multiplier to see how much Pepsico would earn if it were completely debt-free, you will see that the ROE drops to 15.04%. In other words, for fiscal year 2004, 15.04% of the return on equity was due to profit margins and sales, while 15.96% was due to returns earned on the debt at work in the business. If you found a company at a comparable valuation with the same return on equity yet a higher percentage arose from internally-generated sales, it would be more attractive. Compare Pepsico to Coca-Cola on this basis, for example, and it becomes clear (especially after adjusted for stock options) that Coke is the stronger brand.