ROE is calculated as net income applicable to common shares divided by the average book value of common equity: ROE = Net Income / Av. Book Value
A higher ROE is viewed as a positive aspect for the company, but the reason behind it should be examine. From the equation above, we can see that if book value is decreasing more rapidly than net income, the ratio will increase, but this is not good for the firm.
This approach can be used to analyze the ROE. With some algebra we can break down ROE into a function of different ratios. Firstly, we are going to consider the original approach:
Original Dupont Equation: Three-Part Dupont
Taking the ROE equation: ROE = net income / shareholder's equity and multiplying ROE by (revenue / revenue), and rearranging terms we get:
ROE = (net income / revenue) * (revenue / shareholder's equity)
We now have ROE broken into two parts, the first is net profit margin, and the second is the equity turnover ratio. Now we can expand this by multiplying these terms by (assets / assets), and rearranging we end up with the three-step DuPont equation.
ROE = (Net Income / Revenue) * (Revenue / Assets) * (Assets / Shareholder's Equity)
This equation for ROE breaks it into three widely used and studied components:
ROE = (Net profit margin)* (Asset Turnover) * (Leverage ratio)
The first term is what we called previously net profit margin, the second term is asset turnover and the third tem is a financial leverage ratio. If we have a low ROE, one of the following must be true:
- The firm has a poor profit margin
- The firm has a poor asset turnover
- The firm has a little leverage
ROE (%) 3-Step
Net Profit Margin
As outlined in the article, a key ratio used to determine management efficiency is the ROE. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time. So let´s see the evolution on the next chart:
As we can appreciate, the ROE has decreased since 2008 and it can be attributed to the decline in profitability as measured by the Net Profit Margin. Nevertheless, the ROE of Novartis is more than 12% in all the period analyzed, which I think is a very good sign of management.
Hedge fund gurus have also been active in the company. Gurus like Steven Cohen (Trades, Portfolio), Lee Ainslie (Trades, Portfolio), Sarah Ketterer (Trades, Portfolio), Bill Frels (Trades, Portfolio), Irving Kahn (Trades, Portfolio), Ken Fisher (Trades, Portfolio), John Buckingham (Trades, Portfolio) and Murray Stahl (Trades, Portfolio) have taken long positions in the first quarter of 2014.
Disclosure: Omar Venerio holds no position in any stocks mentioned.