Return on Equity and Assets, and the DuPont Equation
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Return on Equity and Assets, and the DuPont Equation
Return on equity and assets
Return on equity (ROE) measures profits per dollar of the capital that shareholders have invested in the company. Meanwhile, return on assets (ROA) measures the same thing, but over the entire asset base, not just equity. Both are good measures of the overall profitability of a company. Companies with economic moats will usually have higher returns than their competitors.
Things To Know
- Return on equity and return on assets measure profits per dollar of assets.
Benchmarks to use
There are two decent return benchmarks that can be used across most industries: If a company has generated ROAs in excess of 10% and/or its ROEs have been in excess of 15% for some time, the company may indeed possess a moat.
The DuPont equation and ROA
Margin and turnover, two otherwise valuable measurements, mean little when used by themselves and should be compared with the margins and turnover ratios of other, very similar companies. There is one equation, the so-called DuPont equation, that helps tie all the concepts together. The DuPont equation simply breaks down the components of ROA and ROE. You may recall the following formula for ROA (for simplicity, we will ignore aftertax interest expenses):
Return on Assets = Net Profits / Average Assets
But we can also express ROA this way:
Return on Assets = Asset Turnover x Net Profit Margin
If we break this equation down further by defining turnover and margin, we can see why this works—sales in the definitions of turnover and margin cancel each other out.
ROA = (Sales / Average Assets) x (Net Profits / Sales) = Net Profits / Average Assets
We aren't just doing random algebra for fun here. Rather, this highlights the two different ways a company can create high returns for itself. Companies can either use their assets more efficiently to generate sales, or they can have higher profit margins, or both.
DuPont and ROE
To use the DuPont equation to calculate a company's ROE, we have to add a step to the process to account for the amount of leverage (debt) a company employs. We can break down ROE using the DuPont equation as follows:
ROE = ROA x (Asset / Equity Ratio)
ROE = (Asset Turnover) x (Net Profit Margin) x (Asset / Equity Ratio)
ROE = (Sales / Average Assets) x (Net Profits / Sales) x (Average Assets / Average Equity)
=
(Net Profits) / (Average Equity)
Notice that in the ROE breakdown, both sales and average assets cancel each other out.
One can draw the same insights about operating efficiency (profit margins) and asset use efficiency (turnover) as with ROA, but this adds the element of leverage to the equation. Clearly, companies can use leverage (debt) in order to boost their ROEs.