The Return on Equity ratio measures how well the shareholders' investment in the company are generating net income. It is one of the most important indicators of a company's profitability and potential growth and one of Warren Buffett favourite calculations for finding quality companies.
Generally, a high ROE means that the rate of return on shareholders' equity is rising, a high and consistent ROE indicates that the management is putting the shareholders' money to good use and growing profits without adding new equity into the company.
However, this ratio can be misleading as ROE can be easily manipulated. A high ROE can be produced without increasing the performance of the company by manipulating the equity portion of the ROE formula. The formula for ROE is Net Income / Shareholders' Equity, shareholders' equity being the denominator, any decrease in the shareholders' equity will result in higher ROE even with no increase or even an decrease in net income. While using debt to finance a company growth can often produce higher returns, it can also place the company in a riskier position especially during down markets.
DuPont Analysis provides a way to breakdown the components of ROE and a much better understanding of how ROE is achieved. DuPont Analysis is also known as DuPont Identity, DuPont Formula, DuPont Model or the DuPont Method. It is a method of performance measurement that was created by DuPont corporation back in the 1920s.
The DuPont Analysis breaks down the ROE into three distinct components:
1) Profitability - measured by profit margin (Net Income / Sales)
2) Operating efficiency - measured by asset turnover (Sales / Total Assets)
3) Financial leverage - measured by equity multiplier (Total Assets / Shareholders' Equity)
The basic formula for DuPont Analysis is:
ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Shareholders' Equity)
With ROE broken down into three components, it becomes clearer how ROE is achieved. If the increase in ROE is the results of increase in profit margin or asset turnover, it is a very positive sign. However, if the equity multiplier is the source of increase and the company is already appropriately leveraged, then it is a warning sign.
Looking at DuPont Analysis for a single company over a single year, the result would be meaningless. The best way is to use the DuPont Analysis is to compare against competitors in the same industry over some period of time. This will show trend of the company against itself and against that of the competitors.
Example of DuPont Analysis
I will be comparing Cisco Systems, Inc. (CSCO) against Juniper Networks, Inc. (JNPR), its direct competitor in the Networking & Communication Devices industry, to provide an example of using the DuPont Analysis.
All the above data can be obtain from Yahoo Finance.
The asset turnover and Equity Multiplier for Cisco have been consistent over the three years period, the drop in ROE from 2010 to 2011 and increase in ROE from 2011 to 2012 is due mainly to the changes in profit margin.
The asset turnover for Juniper remain consistent over the three years period, the equity multiplier increase from 2010 to 2011 and maintain the same in 2012. We can see from the Balance Sheet that this is due to the increase in long term debt in the year 2011. The ROE for Juniper has been decreasing since 2010 and this is mainly due to the decrease in the net income.
Cisco is obviously the superior of the two companies. The changes in the ROE is due to the changes in the profit margin and there is no warning sign of ROE being manipulated.