Sep 18, 2010

ROE and the Basic DuPont Model


ROE and the Basic DuPont Model
Calculating the Percentage Return on Capital with the DuPont Model

By thorough analysis of the DuPont Model components, analysts may deduct what rate of return the management has earned on capital invested by the common stockholders.
When evaluating a company’s financial performance, there are two categories of ratios analysts like to employ: operating efficiency ratios and operating profitability ratios. The focus of this article is on a particular profitability ratio—return on owner’s equity (ROE).
This ratio is extremely important to common shareholders because it tells them how hard their money has been put to work by the company’s management. It is expressed in percentage terms after all inflows and outflows on an income statement have been accounted for.
Return on Total and Common Equity
The return on total equity examines the relationship between the total equity from the balance sheet, including preferred shares, relative to the net income from the income statement in the following manner:
Return on Total Equity = Net Income / Average Total Equity
Note that when two types of financial statements are used in conjunction, an income statement and balance sheet, for example, the balance sheet item has to be averaged from one reporting period to the next.
Furthermore, if an analyst wants to consider only the owner’s equity (that would be the common shareholders’ equity) relative to net income, then the following formula must be used:
Return on Owner’s Equity = Net Income – Preferred Dividend / Average Common Equity
Note that the rate of return on owner’s equity reflects the company’s overall business and financial risk, typically assumed by common shareholders. Remember, bondholders have priority claims on a company's assets.
There is another way to analyze this ratio by breaking it down into two profitability ratios: the net profit margin and equity turnover. The net profit margin is calculated by dividing the net income with net sales, while the equity turnover is calculated by dividing the net sales with common equity.
Since the net sales are in the denominator in the net profit margin calculation, and in the numerator in the equity turnover calculation, this item can be canceled out to arrive back to the net income (sans the dividend) divided by the average common equity calculation.
Using the net profit margin and equity turnover ratios implies that a company’s ROE could be improved either through utilizing owner’s capital in a more efficient manner (by increasing the equity turnover), or by running a more profitable business (by increasing the net profit margin).
The Basic DuPont Model
Because ROE is such an important performance indicator, financial theory has broken it down into several key components that provide more detailed insight into the ratio itself, and, more importantly, why it changes. This breakdown of ROE into sum of its parts is called the DuPont Model, or the DuPont System, as some analysts call it.
The DuPont Model calculates ROE by multiplying the following three ratios:
ROE = Net Profit Margin x Total Asset Turnover x Financial Leverage
A company’s net profit margin is calculated by dividing its net income with net sales. As already explained, by improving overall profitability, a company automatically improves its return on invested common capital. Note that this margin measures the relationship between the company’s after-tax net income relative to its sales.
The second ratio, the total asset turnover, is calculated by dividing the net sales with total assets. This ratio is the measure of how effectively a company utilizes its asset base. The total asset turnover ratio has the most meaning when compared to average ranges for specific industries. For example, capital-intensive industries, such as steel and auto manufacturing, have low asset turnover ratios, often less than 1. On the other side of the spectrum are the retail and service industries, with asset turnovers of over 10.
Finally, there is the financial leverage ratio, also called the financial leverage multiplier, which indicates the proportion of a company’s assets financed by debt. All assets are financed either with debt or with equity, and this ratio is calculated by dividing total assets with the company’s common equity. (Note that in the DuPont Model, the common equity item, although found on the balance sheet, is not averaged, but the value from the most recent reporting period is used.)
In essence, the higher the financial leverage ratio, the more assets have been financed with debt. So, if the total assets-to-equity ratio is 2:1, for example, it means that for every two dollars worth of assets, there is one dollar of equity. In other words, half of a company’s assets have been financed by equity and half with debt.
There is also something called the Extended DuPont Model, which offers additional insights into a company’s financial leverage, as well as how taxes impact the company’s return on equity. The concept of the model is the same as the basic version, only there are two more components included in the calculation.
Source: Investment Analysis and Portfolio Management, Eight Edition, by Frank K. Reilly and Keith C. Brown, 2005

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