Return on Equity or ROE is a commonly used ratio which measures a company’s financial performance by dividing net income by the total shareholders' equity. In order to understand whether the company has significant ROE ratio or not, one needs to compare it with the ROE’s of peer companies.
For example, if a company XYZ Ltd has a ROE of 15% and its industry group has ROE of 10%, this means that the XYZ Ltd is better than its industry peers in utilizing assets to create profits.
Although the formula for ROE is quite simple i.e. ROE = Net profit after tax (PAT) / Shareholder’s equity (Equity)
But one needs to understand that this formula is composed of several other ratios which are: net profit margin asset turnover ratio and Assets/Equity ratio.
ROE = (PAT/Sales) *(Sales/Assets) *(Assets/Equity)
DuPont analysis is a type of analyses which makes use of this decomposed formula to better understand a company’s financial health.
Developed by DuPont Corporation in the 1920s, DuPont analysis is a technique used by analysts to learn more about the strengths and weaknesses of a company by carefully understanding its Return on Equity (ROE) ratio. Under this analyses, the return on equity of a company is decomposed so that the investors can focus on the key metrics of the company’s financial performance.
Return on equity is comprised of three major financial metrics:
- Operational efficiency - represented by net profit margin
- asset use efficiency – Represented by asset turnover ratio
- financial leverage
ROE = (PAT/Sales) *(Sales/Assets) *(Assets/Equity)
Extended DuPont equations further decomposes net profit margin:
ROE= (Net income/EBT) * (EBT/EBIT) * (EBIT/Revenue) * (revenue/avg. total assets) * (avg. total assets/avg. equity)
DuPont analysis provides an important indicator of company-wide financial performance and insight into company’s operations and this analyses is very essential for an investor as it answers the question what is actually causing the ROE to be what it is. DuPont equation provides a broader picture of the return, the company is earning on its equity. It shows where a company’s strength lies and where there is a room for improvement.
ROE is a considered as a very useful measure for comparing a company against its competitors. Higher ROE is usually seen as a positive sign as it means that the company is using its investments efficiently to generate earnings growth.
A company can increase its ROE if it-
- Generates a high Net Profit Margin
- Effectively uses its assets so as to generate more sales
- Has a high Financial Leverage
Instead of just taking ROE into consideration, if we analyze all three measures which collectively form ROE, one can have a better understanding of a stock.
To understand this further, let’s take an example of Saracen Mineral Holdings Limited (ASX: SAR), an ASX-listed Gold miner. Based on its FY19 results, SAR has a ROE of 21.2% which is significantly higher if compared to the industry median of 12%. Although ROE is in a good position, we don’t know how efficiently the company’s operations are being done, how good the asset are being used and how well the debt is deployed in the company.
To have more clarity, one needs to carefully analyze the net profit margin, asset turnover ratio and financial leverage of the company.
To know about its operational efficiency we need to look at the company’s Net profit which currently stands at 16.6%, higher than the industry median of 10.9%, demonstrating that the company is more operationally efficient as compared to its industry peers.
In order the understand whether, the company is properly utilizing its assets to generate sales, we will now look at the company’s Asset turnover ratio which current stand at 0.93x, higher than the industry median which is at 0.56x. This represents that if compared to the industry, SAR is utilizing assets more efficiently than its peers to generate revenue or sales.
Now, to have a better understanding about the financial leverage of the company we will look at the Asset/ equity ratio which indicates company's leverage (debt) used to finance the firm. SAR’s Assets/Equity ratio is at 1.38x which is lower than its Industry median of 1.93x.
With this, we now have a better understanding of the company operational efficiency, asset use efficiency and financial leverage of a company. This could not have been possible if we had just looked at the ROE numbers.
Now let us take one more example - Ramsay Health Care Ltd (ASX: RHC), a popular healthcare stock which currently has a ROE of around 22.3%.
By digging deeper, we have identified that the stock has a Net margin of 5% which is higher than the industry median of 3.6, asset turnover of 1.06x which is higher than industry median of 0.87x and asset to equity ratio of 5.47x which is higher than the industry median of 2.82x. Now if in this case we have simply gone through the ROE, we would not have known about the financial leverage position of the company. Hence, it is important to all look all three measures individually while valuing a stock.
Based on the above-mentioned examples, it can be concluded that a company can raise its ROE by maintaining a high-profit margin, increasing asset turnover, or leveraging assets more effectively.
One of the drawbacks of DuPont analyses is that it is only useful when comparison is done between the companies which belongs to the same industry. Before using DuPont analyses, one should carefully study its befits and the drawback, so that the analyses can be done in a more informed manner.
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