Let's analyze an important financial ratio for investors, which is one of the best measure of performance for a company's management: the return on equity (ROE).
The ROE is calculated as net income applicable to common shares divided by the average book value of common equity: ROE = Net Income/Average Book Value
For average book value, we refer to the one at time t and t-1; because numerator and denominator are different variables in their nature, analysts consider the mean when accounting for the equity.
The higher the ROE, the better for company's management, but not so quickly, because according to the equation above, if book value decreases more rapidly than net income, the ratio will increase, and this is not good.
Original Dupont analysis
With some algebra, ROE can be broken into a function of different ratios. Let's consider the initial approach named Original Dupont equation: Three-part Dupont.
Taking the initial 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 multiply these terms by (assets/assets), and rearrange 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 term is a financial leverage ratio. If we have a low ROE, one of the following statements must be true:
• The company has a weak profit margin.
• The company has a poor asset turnover.
• The company has a little leverage.
Let´s see the 10-year ROE evolution of Best Buy Co. Inc. (BBY, Financial).
Now, in the next chart we can see the three ratios all together:
Please note that Equity to Asset is the inverse of the leverage ratio. From the graph, we can conclude that the main reason for the variation of ROE is the volatility in the net profit margin.
Final comment
As outlined in the article, a key ratio used to determine management efficiency is the ROE. In general, analysts consider ROE ratios in the 15% to 20% range as representing attractive levels for investment. Last year, for the entire market the ROE was about 12% to 13%.
It is highly important to understand this metric before investing, and most important is to look at the trend over time.
Disclosure: The author holds no position in any stocks mentioned.
