The DuPont system is widely taught because by interpreting the ROE of a company through various other ratios, we can quickly gain insight into the various operations of a company and understand which aspects could be improved to generate a higher ROE. The DuPont analysis breaks the ROE of a company apart in three different stages, with each stage using a different set of related ratios, beginning with the basic ROE equation.
ROE = Net Income/Average Shareholder’s equity
- ROE = [Net Income/Average total assets] x [Average Total Assets/Shareholders equity]
- ROE = ROA x Leverage
Here we see that ROE is a function of ROA and leverage. The higher the ROA the better, and increasing leverage can have a positive effect. However, if the marginal cost of borrowing exceeds the return on investing in the business, ROA will decrease. Thus ROE in this view is a measurement of the management’s skill on using leverage effectively.
- ROE = [Net Income/Revenue] x [Revenue/Total Assets] x [Average Total Assets/Average Shareholder Equity]
- ROE = Net Profit Margin x Total Asset Turnover x Leverage
By breaking ROA down into Net Profit Margin and Total Asset Turnover, we introduce a profitability and efficiency ratio to our ROE analysis. This allows us to see whether management is driving increasing ROE with cost-cutting or improved utilization of its assets for instance.
- ROE = [Net Income/EBT] x [EBT/EBIT] x [EBIT/Revenue] x [Revenue/Total Assets] x [Average Total Assets/Average Shareholder’s Equity]
- ROE = Tax burden x Interest Burden x EBIT Margin X Total Asset Turnover x Leverage
With this final decomposition, we can assess a company’s ROE quality over a variety of rations. We see that tax burden is not necessarily in control of management, and could be an external influence on ROE. We also see that interest burden does depress ROE even if leverage does not necessarily do so. A high cost of borrowing can be a signal of ROE quality. Finally, we add an operating profitability ratio, which shows the strength a company’s core businesses in contributing to its ROE.
The uses of ROE can be helpful in forecasting. By identify which areas of the business are acting on the ROE, we can make predictions based on those changes. For instance, if we know that the operating profitability of a commodities company is dropping, this points us to performing further analysis on the commodity sector for our forecasts.