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 ModelThere 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 MarginThe 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):
- Net Income ÷ Revenue
- 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 managements part could lead to tremendous losses with little or no warning.
Asset TurnoverThe 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 MultiplierIt 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 EquityTo 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).
PepsicoTo help you see the numbers in action, Ill walk you through the calculation of return on equity using figures from Pesicos 2004 annual report. The key figures Ive 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%