For those who want to study it in more depth, one way of doing this is via an analysis that generally is credited to Donaldson Brown while working at E. I. Du Pont de Nemours and Company during the 1920s and is referred to as the DuPont analysis. (Even though the official name of the company is E. I. Du Pont de Nemours and Company, in all its publications and reports it refers to itself as DuPont.)
The analysis proceeds by decomposing return on equity (ROE) into three components:
Operating efficiency measured by net profit margin (NPM) or net earnings divided by sales,
Asset use efficiency measured by total asset turnover (TAT) or sales divided by assets, and
Financial leverage measured by the financial leverage multiplier (FLM) or assets divided by equity.
The specific formula is: ROE = NPM x TAT x FLM.
Companies from different sectors and industries may have similar returns on equity, but when scrutinized using the DuPont analysis it becomes clear that they are often obtained in quite different ways. For example, retail companies such as supermarket chains tend to have very low net profit margins and moderately low financial leverage. To obtain a satisfactory return on equity they need to have high asset turnover. For this reason when analyzing a chain of retail stores it is prudent to look at growth of same store sales rather than relying solely on the company continually opening new stores to obtain growth. Wal-Mart Stores is an example of a company that has low profit margins of around 3-4% but achieves excellent return on equity through a high total asset turnover.
Other industries, such as fashion and high-tech with strong brand names and intellectual property, often have much higher profit margins. In this case, the ability to increase sales through an increase in prices becomes a crucial issue. An example of a high net profit margin company is the software company Microsoft Incorporated with a net profit margin of around 27%. Another example is Coach Incorporated, the designer and marketer of handbags and other accessories, with a level of approximately 25%.
Finally there are industries that achieve high return on equity through taking on substantial debt giving them high financial leverage. Banks and financial institutions often fall into this category. Their levels would be considered unacceptably risky for most industrial companies. American Express, the global payments and travel company, is an example of a company with a very high level of financial leverage; it is over 13.
The following table lists a breakdown of the return on equity of Wal-Mart, Microsoft, Coach and American Express. The return on equity for these companies ranges from high to very high. Using the DuPont analysis it becomes clear that they generate this return in quite different ways.
|Company||Ticker||Return on Equity||Net Profit Margin||Total Asset Turnover||Financial Leverage|
The next table gives the DuPont analysis of some Australian companies. Woolworths is Australia's largest chain of grocery stores. Notice its low profit margin which is compensated for by high asset turnover. ARB makes equipment for off-road and 4WD vehicles and Flight Centre is chain of travel agencies. Because of their brand names they are able to generate a higher profit margin from their sales. Macquarie Group is Australia's leading investment bank with approximately 40% of its revenues earned overseas. It has high financial leverage which some analysts say is too high.
|Company||Symbol||Return on Equity||Net Profit Margin||Total Asset Turnover||Financial Leverage|