Return on equity (ROE) is a closely watched number among knowledgeable investors.

It is a strong
measure of how well the management of a company creates value for its shareholders. The number can
be misleading, however, as it is vulnerable to measures that increase its value while also making the
stock more risky. Without a way of breaking down the components of ROE investors could be duped into
believing a company is a good investment when it's not. Read on to learn how to use DuPont analysis to
break apart ROE and get a much better understanding about where movements in ROE are coming from.
(To learn the basics and value of return on equity, check out Keep Your Eyes On The ROE.)

ROE: Simple, Perhaps Too Simple

The beauty of ROE is that it is an important measure that only requires two numbers to compute: net
income and shareholders equity.

ROE = net income / shareholder's equity

If this number goes up, it is generally a great sign for the company as it is showing that the rate of return
on the shareholders equity is going up. The problem is that this number can also rise simply when the
company takes on more debt, thereby decreasing shareholder equity. This would increase the leverage of
the company, which could be a good thing, but it will also make the stock more risky.

Three-Step DuPont

To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In the 1920s the DuPont
corporation created a method of analysis that fills this need by breaking down ROE into a more complex
equation. DuPont analysis shows the causes of shifts in the number.

There are two variants of DuPont analysis, the original three-step equation, and an extended five-step
equation. The three-step equation breaks up ROE into three very important components:
ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)
These components include:

 Operating efficiency - as measured by profit margin.

 Asset use efficiency - as measured by total asset turnover.
 Financial leverage - as measured by the equity multiplier.

The Three-Step DuPont Calculation

Taking the ROE equation: ROE = net income / shareholder's equity and
multiplying the equation by (sales / sales), we get:

 ROE = (net income / sales) * (sales / shareholder's equity)

We now have ROE broken into two components, the first is net profit margin, and
the second is the equity turnover ratio. Now by multiplying in (assets / assets),
we end up with the three-step DuPont identity:

 ROE = (net income / sales) * (sales / assets) * (assets /

 shareholder's equity)

This equation for ROE, breaks it into three widely used and studied components:

 ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

We have ROE broken down into net profit margin (how much profit the company gets out of its revenues),
asset turnover (how effectively the company makes use of its assets), and equity multiplier (a measure of
how much the company is leveraged). The usefulness should now be clearer.

If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very
positive sign for the company. However, if the equity multiplier is the source of the rise, and the company
was already appropriately leveraged, this is simply making things more risky. If the company is getting
over leveraged, the stock might deserve more of a discount, despite the rise in ROE . The company could
be under-leveraged as well. In this case it could be positive, and show that the company is managing
itself better. (Learn to take a deeper look at a company's profitability with the help of profit-margin ratios in
The Bottom Line On Margins.)

Even if a company's ROE has remained unchanged, examination in this way can be very helpful.
Suppose a company releases numbers and ROE is unchanged. Examination with DuPont analysis could
show that both net profit margin and asset turnover decreased, two negative signs for the company, and
the only reason ROE stayed the same was a large increase in leverage. No matter what the initial
situation of the company, this would be a bad sign.

Five-Step DuPont
The five-step, or extended, DuPont equation breaks down net profit margin further. From the three-step
equation we saw that, in general, rises in the net profit margin, asset turnover, and leverage will increase
ROE. The five-step equation shows that increases in leverage don't always indicate an increase in ROE.

The Five-Step Calculation

Since the numerator of the net profit margin is net income, this can be made into
earnings before taxes (EBT) by multiplying the three-step equation by 1 minus
the company's tax rate:

 ROE = (earnings before tax / sales) * (sales / assets) * (assets /

equity) * (1 – tax rate)

We can break this down one more time, since earnings before taxes is simply
earnings before interest and taxes (EBIT) minus the company's interest expense.
So, if a substitution is made for the interest expense, we get:

 ROE = [(EBIT / sales) * (sales / assets) – (interest expense / assets)]

 * (assets / equity) * (1 – tax rate)

The practicality of this breakdown is not as clear as the three-step, but this
identity provides us with:

 ROE = [(operating profit margin) * (asset turnover) – (interest

expense rate)] * (equity multiplier) * (tax retention rate)

If the company has a high cost of borrowing, its interest expenses on more debt could mute the positive
effects of the leverage. (To learn how to use revenue and expenses to break down and analyze a
company, read Understanding the Income Statement.)

Learn The Cause Behind The Effect

Both the three- and five-step equations provide deeper understanding of a company's return on equity, by
examining what is really changing in a company rather than looking at one simple ratio. As always with
financial statement ratios, they should be examined against the company's history and its competitors.

For example, when looking at two peer companies, one may have a lower ROE. With the five-step
equation, you can see if this is lower because: creditors perceive the company as riskier and charge it
higher interest, the company is poorly managed and has leverage that is too low, or the company has
higher costs that decrease its operating profit margin. Identifying sources like these leads to better
knowledge of the company and how it should be valued. (To learn how to easily compare companies,
read Peer Comparison Uncovers Undervalues Stocks.)