A useful ratio for investors, which is arguably the best measure of performance for a company's management team, is the return on equity.
The ratio is calculated as net income applicable to common shares divided by the average book value of common equity.
For average book value, we often take the value at time t and t-1 and consider the mean. The reason for this is that the numerator and denominator are different variables in their nature, so analysts consider the mean when accounting for the equity.
Most of the time, the higher the ROE, the better for a company's management. But if book value decreases more rapidly than net income, the ratio will increase, which is not a good indicator.
Original Dupont analysis
ROE can be broken into a function of different ratios. Let's consider the initial approach, which is called the original DuPont equation.
In the initial equation, ROE equals net income divided by shareholder's equity and then multiplied ROE by (revenue/revenue) and rearranging terms to get:
ROE = (net income / revenue) * (revenue / shareholder's equity)
The ROE was broken into two parts, the first is net profit margin and the second is the equity turnover ratio. Now we can multiply these terms by (assets/assets) and rearrange to end up with the three-step DuPont equation.
ROE = (Net Income / Revenue) * (Revenue / Assets) * (Assets / Shareholder's Equity)
Now, ROE is broken into three widely used 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 term is the financial leverage ratio. If we have a low ROE, one of the following statements must be happening:
- The company has a weak profit margin.
- The company has a poor asset turnover.
- The company has a little leverage.
Let's now analyze the five-year ROE evolution of The Coca-Cola Co. (
KO, Financial):Dec 2019 | March 2020 | June 2020 | September 2020 | December 2020 | |
ROE % | 43.34% | 59.78% | 39.93% | 38.5% | 30.73% |
Coca-Cola's average total stockholders equity for the quarter that ended in December 2020 was $18.95 billion. Therefore, Coca-Cola's annualized ROE for the quarter was 30.73%.
Moreover, during the past 13 years, Coca-Cola's highest ROE was 49.61%, the lowest was 6.22% and the median was 27.13%. Thanks to GuruFocus, we can know that the ratio is ranked higher than 96% of the 93 companies in the nonalcoholic beverages industry.
Coca-Cola's net margin was 16.91% and the asset turnover was 0.09. Please note that the leverage ratio is more than 2.
Final comment
As outlined previously, the ROE is a key ratio used to measure management efficiency. In general, analysts consider ROE ratios in the range between 15% and 20% to be attractive.
It is highly important to understand this metric before investing, and to look at the trend over time.
Disclosure: The author holds no positions in any stocks mentioned.
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