ROE and DuPont Analysis

ROE: the shareholders' return

ROE = net income ÷ shareholders' equity: how much a year shareholders earn on each $1 they put in. DuPont analysis breaks it into three factors multiplied together.

Three ways to make money

A high net margin means “earns a lot per sale” (luxury goods), a high asset turnover means “sells fast” (supermarkets), and a high equity multiplier means “borrows a lot” (banks). Multiply the first two and you get ROA.

Discount a leverage-driven ROE

An equity multiplier of 10 means each $1 of shareholders' money supports $10 of assets: if assets lose just 10%, shareholders' equity is wiped out. For the same ROE, the kind built on debt is the most fragile.

Key takeaways

• ROE = net income ÷ shareholders' equity: how much shareholders earn each year for every $1 they've put in.
• DuPont analysis: ROE = net margin × asset turnover × equity multiplier. The first two multiplied together give ROA.
• ROE propped up by the equity multiplier (debt) is the most fragile: with a 10x equity multiplier, a 10% drop in assets wipes out shareholders' equity.
• An ROE that stays high over the long run without relying on heavy debt usually signals a strong competitive advantage.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Click “Luxury brand”, “Supermarket chain” and “Bank” in turn: what's each one's ROE? Which factor drives each?
2. In the “Bank” preset, look at the stress test: how much shareholders' equity is left if assets lose 5%? And at 10%?
3. In “Supermarket chain”, lower asset turnover from 2.5 to 1.5: what does ROE become?
4. Set the equity multiplier to 1 (no borrowing at all): how are ROE and ROA related now?

Quiz and explanations

1. Net margin is 10%, asset turnover 1.2 and the equity multiplier 2. What's the ROE?

Answer: 24%.10% × 1.2 × 2 = 24%.

2. Two companies both have a 20% ROE: A has an equity multiplier of 1.3 and B of 8. Whose ROE is more fragile?

Answer: B.B's ROE is mostly amplified by debt, so even a small drop in assets does serious damage to equity.

3. Net income is $3 billion, with shareholders' equity of $18 billion at the start of the year and $22 billion at the end. Using average equity, what's the ROE?

Answer: 15%.Average equity = (18 + 22) ÷ 2 = $20 billion; 3 ÷ 20 = 15%.

Terms in this lesson

• asset turnover (Asset Turnover): Revenue ÷ total assets: how much revenue each $1 of assets brings in a year, showing how hard the assets are working.
• DuPont analysis (DuPont Analysis): Breaking ROE into net margin × asset turnover × equity multiplier to see whether a company earns through margins, speed of turnover or debt.
• equity multiplier (Equity Multiplier): Total assets ÷ shareholders' equity, a measure of how much debt is used; a multiplier of 5 means each $1 of shareholder money supports $5 of assets.
• net income (Net Income): The profit left after all costs, expenses, interest and taxes.
• net margin (Net Margin): Net income ÷ revenue: how much of each $1 of revenue ends up as profit.
• ROA (Return on Assets): Return on assets: net income ÷ total assets, or how much each $1 of assets earns in a year, whether funded by debt or shareholders.
• ROE (Return on Equity): Return on equity: net income ÷ shareholders' equity, or how much each $1 shareholders put in earns in a year.
• shareholders' equity (Shareholders' Equity): What's left after subtracting liabilities from assets, which belongs to shareholders; also called net assets.