Return on Equity -- the Dupont Model

Original article is here.

ROE formula is very simple and easy understanding.

ROE = Net Profit / Average shareholder equity for period

However, in the above article, there are three components in the calculation using the traditional DuPont model: the net profit margin, asset turnover, and the equity multiplier.  By examining each input individually, we can discover sources of a company's return on equity and compare it to its competitors.

ROE calculation using DuPont model:

ROE = Net profit margin x Asset turnover x equity multiplier
=(Net income / Revenue) x (Revenue / Assets) x (Assets / Shareholder's equity)

Asset turnover tends to be inversely related to the net profit margin: the higher the net profit margin, the lower the asset turnover.  The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.

The equity multiplier is a measure of financial leverage that allows the investor to see what portion of the return on equity is the result of debt.  If you found a company at a comparable valuation with the same return on equity yet a higher percentage arose from internally-generated sales, not from equity multiplier, it would be more attractive.  We can assume equity multiplier = 1, and calculate the ROE without leverage effect from debt.