Breaking Down ROE Using the

DuPont Formula
By Z. Joe Lan, CFA

Article Highlights
ROE calculates the return a company earns from shareholders equity.
The DuPont formula reveals the source of those returns: sales, marketing or debt.
Comparing a companys nancial performance to its peers can provide a useful context for analyzing ROE.

Retur n on equity be the average shareholders equity,

(ROE) is a commonly which is calculated by taking the
used profitability ratio that average of the shareholders equity
for the beginning and the end of
measures the effectiveness the fiscal period. It is generally
of management in generat- more accurate to use average share-
ing earnings for shareholders. holders equity for the denominator
Return on equity measures net since the ratio compares an income
income less preferred dividends against statement item (which lists data over
total stockholders equity. The three primary driv- a period of time) to a balance sheet item
ers of ROE are better sales (or turnover), greater margins (which lists financial data for a point in time).
and higher debt levels, each of which can lead to a higher Investors analyze ROE against historical trends and
ROE. Although return on equity is a useful tool, it does not industry benchmarks. A rising ROE signals that the firm is
tell you what factors are helping or hurting the companys earning more profits from its net assets relative to previous
performance. The DuPont formula addresses this concern years. In addition, a firm generating a level of ROE in ex-
by breaking down ROE and allowing investors to see which cess of industry norms is likely more efficient at generating
characteristics are driving ROE. Analysis of the DuPont earnings than its peers. Generally speaking, a higher ROE is
formula allows you to determine whether management is a positive sign. However, simply looking at the ROE paints
generating value for shareholders effectively. an incomplete picture.
As stated previously, ROE is a measure of company
Return on Equity or management efficiency. Yet, each company has its own
unique circumstances. For example, since ROE measures net
Return on equity measures the level of income attributed income against shareholders equity, it does not take into ac-
to shareholders against the investment that shareholders put count company assets funded by raising debt. As I previously
into the firm. In other words, it measures how efficiently pointed out in this series on financial statement analysis, a
a company is able to generate profits using shareholders company can raise capital either through shareholders by is-
equity, which includes stock offerings and retained earnings. suing additional equity or by issuing additional debt through
There are different ways to calculate ROE. The denomi- bonds or notes. (See The Cash Flow Statement: Tracing the
nator of the equation, total shareholders equity, can simply Sources and Uses of Cash in the July 2012 AAII Journal.)
be the shareholders equity at the end of the period, which is By issuing additional debt to fund a project, a company is
found on the balance sheet. Alternatively, the figure used can able to increase its ROE if the project is profitable since no

20 AAII Journal
 Financial Statement Analysis

additional equity was issued, Table 1. Historical Analysis of ROE Using DuPont Formula
causing net income to increase
without any increase in share- Example data comes from the income statement, balance sheet and cash flow state-
holders equity. The key point ment found in the Financial Statement Analysis columns in the March, May and July
is that profit generated by using 2012 issues of the AAII Journal, which are linked to this table online.
additional debt must exceed the
cost of funding, or the interest Dollar amounts are in millions of dollars.
payments. This process is known
as leverage. Alternatively, a firm Year 2011
may retire outstanding shares by Net profit margin = net income sales
issuing debt, thereby causing the = $82.75 $1,000 = 8.275%
ROE figure to increase again Asset turnover ratio = sales assets
without really creating additional = $1,000 $1,485 = 0.673
firm value. Equity multiplier = assets equity
Therefore, by simply look- = $1,485 $418 = 3.553
ing at ROE, one is not able to ROE = net profit margin asset turnover ratio equity multiplier
tell the underlying drivers for = 0.08275 0.673 3.553 = 19.8%
an increase or decrease in ROE.
For this reason, the DuPont Year 2010
formula was created. Net profit margin = net income sales
= $63.25 $800 = 7.906%
The DuPont Formula Asset turnover ratio = sales assets
= $800 $1,297 = 0.617
The DuPont for mula Equity multiplier = assets equity
breaks down ROE into three = $1,297 $290 = 4.472
distinct elementsprofitability, ROE = net profit margin asset turnover ratio equity multiplier
efficiency and financial leverage. = 0.07906 0.617 4.472 = 21.8%
The formula is used by inves-
tors to compare and analyze the
source of a companys ROE compared interest and taxes are accounted for. the lowest price on Tide or Cheerios.
to historical trends or other companies The margin is a representation of a Companies operating in industries with
in similar industries. The DuPont for- firms pricing strategy and depends on low barriers to entry will also see their
mula breaks down ROE as follows: several key factors. margins erode as new companies jump
Needless to say, companies try to into the fray. An example is the electron-
ROE = net profit margin asset turnover find the optimal price point for their ics industry, where low-cost producers
equity multiplier products and services; one that maxi- have driven down the price of television
mizes profits. The higher at which the sets, while traditional brick-and-mortar
Alternatively, the DuPont formula price is set, the lower the sales volume retailers are losing market share to online
can be written as follows: will be, and vice versa. From an eco- competitors.
nomics standpoint, the price should be In contrast, companies able to
ROE = (net profit sales) (sales set at a level where price multiplied by sustain higher profit margins offer a
assets) (assets equity) volume is the greatest. Of course, reality differentiated, or one-of-a-kind, prod-
is much more complicated. uct. These companies face decreased
Though a company can increase its Profit margins are usually a direct competitive pressures and often operate
ROE by taking on additional leverage, result of competition that a company in industries with high barriers to entry.
it is generally more desirable for firms faces. In highly competitive industries, These companies tend to create prod-
to increase their margins or turnover. profit margins tend to be lower. Indus- ucts with high intellectual property value
tries with products that have very little or on which they own patents. Firms in
Net prot margin differentiation, which are commonly these industries generally compete on
Net profit margin is calculated by known as commodity products, are not product quality, features and innovation.
dividing net income by sales. Simply put, able to achieve high profit margins. A
this margin shows the net profits that good example of such companies is Asset turnover
a firm earns for each dollar of sales it grocery stores. There is little differen- The asset turnover ratio is calculated
generates after the costs of producing tiation between products. A shopper by dividing sales by total assets. The ratio
and selling goods, overhead expenses, will choose a convenient store that has is a measure of how efficiently manage-

December 2012 21
 Table 2. Competitive Analysis of ROE Using DuPont Formula become less efficient in generating
income using shareholders equity.
Dollar amounts are in millions of dollars, based on fiscal-2011 financial statement The company was able to generate
data. $0.218 of income per dollar of
shareholders equity in 2010, but
Apple Inc. (AAPL) was only able to generate $0.198
Net profit margin = net income sales per dollar of equity in 2011. Us-
= $25,922 $108,249 = 23.947% ing the DuPont formula provides
Asset turnover ratio = sales assets a clearer story, however.
= $108,249 $95,777 = 1.130 Breaking down ROE into
Equity multiplier = assets equity DuPont formula components
= $95,777 $62,203 = 1.540 shows that the firms net profit
ROE = net profit margin asset turnover ratio equity multiplier margin increased from 7.9% in
= 0.23947 1.130 1.540 = 41.7% 2010 to 8.3% in 2011. The firm
also increased its asset turnover
Hewlett-Packard Co. (HPQ) ratio from 0.62 in 2010 to 0.67
Net profit margin = net income sales in 2011. ROE decreased due to
= $7,074 $127,245 = 5.559% significant deleveraging by the
Asset turnover ratio = sales assets firm, with its equity multiplier
= $127,245 $127,010 = 1.002 decreasing from 4.47 in 2010 to
Equity multiplier = assets equity 3.55 in 2011. These figures suggest
= $127,010 $39,537 = 3.212 that during 2011, the firm was
ROE = net profit margin asset turnover ratio equity multiplier able to generate higher margins
= 0.05559 1.002 3.212 = 17.9% while increasing volume of sales
for each unit of asset held, both
of which indicate higher man-
ment is able to drive sales from company pany to raise its ROE by increasing its agement efficiency. The reason for the
assets. For the most part, volume is not equity multiplier. Conceptually, it is easy firms decrease in ROE was due to the
as critical for higher-margin companies to see how this works. Firms can fund firm using proportionately less debt in
as it is for lower-margin companies since additional projects using debt instead relation to shareholders equity.
each sale is more profitable. Higher- of additional equity. If the project is By most accounts, an ROE of 20%
margin companies are able to generate able to generate more sales than the is considered good, but it is much harder
the same absolute dollar of earnings interest payments required to service to assess the strength of each individual
with lower sales volume. the additional debt, ROE is increased as component without comparing them
On the other hand, lower-margin additional profits are generated without to industry norms or a competitor. To
firms need higher sales volume to additional shareholders equity funding. show how industry analysis can be ap-
achieve the same net income. In order However, a firm can become overbur- plied, I used the financial statements
for these companies to generate growth dened with debt if it is unable to keep from AAIIs Stock Investor Pro stock
in earnings, they need the additional up with interest payments, and it may screening program for computer hard-
sales volume since their products lack be forced into bankruptcy. ware companies Apple Inc. (AAPL) and
differentiation and they compete on the Hewlett-Packard Co. (HPQ). Stock Inves-
basis of price. Analysis of the DuPont Formula tor Pro calculates ROE by using average
shareholders equity, which is thought of
Equity multiplier Table 1 provides calculations for as a more accurate assessment.
The final component of the the DuPont formula components using Table 2 shows significant differ-
DuPont formula is the equity multiplier. the financial statements provided in the ences between Apples and Hewlett-
This is calculated dividing assets by first three installments of the Financial Packards figures. Apples ROE is 41.7%,
shareholders equity. This ratio measures Statement Analysis series. For simplic- while Hewlett-Packards is 17.9%. In
the amount of debt a firm uses, or its itys sake, the ROE figure is calculated 2011, the median ROE for the computer
leverage. Basic accounting tells us that by using the ending shareholders equity, hardware industry was 10.7%. This
assets are equal to liabilities plus share- which is found on the balance sheet. shows that Hewlett Packard has a strong
holders equity. Therefore, the higher the The sample companys ROE dropped ROE in relation to the industry median,
ratio, the more debt the company em- from 21.8% in 2010 to 19.8% in 2011. but Apples ROE is still much higher.
ploys in relation to shareholders equity. At first glance, the decrease in ROE is A further breakdown sheds more light.
Issuing more debt enables a com- a signal that company management has Apple has a net profit margin of

22 AAII Journal
 Financial Statement Analysis

23.9% compared to a net profit Table 3. Extended DuPont Formula

margin of 5.6% for Hewlett-
Packard. For every dollar of sales Dollar amounts are in millions of dollars, based on fiscal-2011 financial statement
that Apple generates, it is able data.
to create almost $0.24 of net
profit for its shareholders. On Apple Inc. (AAPL)
the other hand, Hewlett-Packard Tax efficiency = net income pretax profit
is able to only generate $0.06 per = $25,922 $34,205 = 75.784%
dollar of sales. Why is there such Interest efficiency = pretax profit EBIT
a large discrepancy between the = $34,205 $34,205 = 100%
two firms? As stated previously, EBIT profit margin = EBIT sales
firms with high margins tend to = $34,205 $108,249 = 31.598%
exhibit several characteristics, Asset turnover ratio = sales assets
such as operating in industries = $108,249 $95,777 = 1.130
with high barriers to entry and Equity multiplier = assets equity
offering highly differentiated = $95,777 $62,203 = 1.540
products. Barriers to entry in the ROE = 0.75784 1.0 0.31598 1.130 1.540 = 41.7%
computer hardware industry are
similar for both firms. However, Hewlett-Packard Co. (HPQ)
the similarities end there. Apples Tax efficiency = net income pretax profit
main product linesthe Mac, = $7,074 $8,982 = 78.758%
iPhone and iPadare highly dif- Interest efficiency = pretax profit EBIT
ferentiated products compared to = $8,982 $9,677 = 92.818%
Hewlett-Packards. The difference EBIT profit margin = EBIT sales
is even more extreme for an iPad = $9,677 $127,245 = 7.605%
and an iPhone when compared Asset turnover ratio = sales assets
to other tablets and phones, = $127,245 $127,010 = 1.002
though competitors are starting Equity multiplier = assets equity
to catch up. = $127,010 $39,537 = 3.212
On the other hand, Hewlett- ROE = 0.78758 0.92818 0.07605 1.002 3.212 = 17.9%
Packards profit margin is more
indicative of a company that
offers products with less competitive multipliers of 3.21 for Hewlett-Packard profit margin asset turnover equity
advantages. For the typical consumer and 1.54 for Apple. multiplier
buying an everyday laptop, there isnt
a significant difference between a Extended DuPont Formula Alternatively, the DuPont formula
Hewlett-Packard and a Dell. The con- can be written as follows:
sumer would most likely purchase the The extended DuPont formula
cheaper laptop, if the specifications consists of five components instead ROE = (net income pretax profit)
were the same for each. In other words, of three. The main difference between (pretax profit EBIT) (EBIT sales)
these companies computers are closer the original DuPont formula and the (sales assets) (assets equity)
to commodity products than differenti- extended DuPont formula is that the
ated products that customers are willing extended formula breaks down net For analysis purposes, we once again
to pay a premium for. profit margin to show the effects of compare Apple and Hewlett-Packard.
There is not much difference in taxes and interest on ROE, which can Calculations are shown in Table 3.
Apples and Hewlett-Packards asset be very important in company analy- The tax efficiency ratio simply mea-
turnover ratios, both of which are close sis. The original formula showed that sures the effect of taxes on a companys
to 1.00. Apples asset turnover ratio is companies are able to boost their ROE net income. The figure can be calculated
marginally higher, which shows that by becoming more leveraged. Eventu- as one minus the tax rate. (For example,
the company is slightly more efficient ally companies that take on additional the tax efficiency ratio for a firm paying
at driving sales using its assets. debt will reach a point where the cost the 35% corporate tax rate is 0.65, or 1
Hewlett-Packard utilizes long-term of debt will diminish profit margins. 0.35.) Apples tax efficiency ratio is lower
debt, whereas Apple does not, choosing The formula can be written as follows: than Hewlett-Packards, showing that
instead to rely on its large cash balance. Apple pays more taxes as a percentage
The difference can be seen in the equity ROE = tax burden interest burden EBIT of pretax profits than Hewlett-Packard

December 2012 23
does. The ratio can be manipulated by company to have a higher tax efficiency measure of management efficiency
the tax breaks and deductions a par- ratio at the expense of a lower interest and a companys ability to generate net
ticular firm is able to claim. efficiency ratio. income through shareholders equity.
The interest efficiency ratio mea- The third ratio in the formula Through the use of DuPont analy-
sures the effect of interest on ROE. measures the effect of earnings before sis, investors are able to determine the
A higher borrowing cost lowers pretax interest and tax (or EBIT margin) on actual drivers behind a companys ROE.
profit, therefore creating a lower ROE. ROE. This ratio evaluates the effect of The DuPont formula allows you to
You may also use operating income as a companys core business operations on ascertain if a company has been able
the denominator in this ratio to measure its final return on equity. It measures how to effectively use debt to drive stronger
the effect of both interest and non- much EBIT a firm can generate given profits as well as how margins and as-
operating expense. If you choose to use a unit of sales. Apples EBIT margin is set turnover are trending over time. Be
operating income in this ratio, be sure to 31.6%, while Hewlett-Packards EBIT sure to compare ROE and its drivers to
stay consistent and use operating income margin is a respectable 7.6%. Once again, other companies in the same industry
in the EBIT margin ratio. Apples inter- the high margin can be attributed to rather than against all companies. Any
est efficiency ratio is 100%, meaning Apples ability to produce differentiated outliers should be closely examined. An
that they have no interest expense, while products. The final two components, abnormally high margin or turnover is
Hewlett-Packards interest efficiency asset turnover and the equity multiplier, hard to maintain, while an unusually low
ratio is 93%. (Hewlitt-Packards interest are the same for both the traditional and margin or turnover may signal financial
expense was found using the companys the extended DuPont formula. difficulties ahead.
2011 annual report.) This may be one The DuPont formula provides in-
of the reasons why Hewlett-Packard has Conclusion sight on a firms strengths and weakness,
a lower tax rate, since interest reduces which may give you, as an investor, a
taxable earnings. The long-term debt ROE is one of the most widely used better idea of what to look for when
that Hewlett-Packard holds enables the profitability ratios, providing a quick performing fundamental analysis.

Z. Joe Lan, CFA, is an assistant nancial analyst at AAII.

Financial Planning

(continued from page 19)

interest and dividends, plus 3.13% (the the amount available for spending under
Making Good Better annual withdrawal percentage at age 65 the modified RMD rule.
under the RMD strategy) of $100,000.
A potential criticism of the RMD In contrast, a household following the Conclusion
rule is that it results in relatively low unmodified RMD rule would spend
consumption early in retirement. While just $3,130. Rather than attempt the complex
this outcome might be optimal for some Figure 3 compares the SEW of the calculations necessary to arrive at an
households, particularly those fearful of modified RMD strategy with the SEWs optimal strategy for drawing down
rising health care costs, others might of the strategies reported in Figure 2. and spending their retirement savings,
prefer greater consumption at younger At a factor of 1.03, it outperforms all retirees rely on easy-to-follow rules of
ages when they are better able to enjoy the alternatives, including the unmodi- thumb, such as the 4% rule advocated
it. This result could be achieved by a fied RMD rule. The disadvantage of by some financial planners. This article
modification to the RMD rule, namely the modified RMD rule is its greater suggests that the IRS required mini-
to consume interest and dividends (but complexity. Although 401(k) and IRA mum distribution rules may be a viable
not capital gains), plus the RMD per- statements report interest and dividends, alternative.
centage of financial assets. To illustrate, households must extract this informa- For financial and practical reasons,
a 65-year-old couple with financial as- tion and perform the necessary calcu- the effectiveness of the alternative
sets of $102,000 who received $2,000 lations to determine their withdrawal RMD strategy compares favorably to
of interest and dividends in the last amount. One solution might be for traditional rules of thumb. And a modi-
year, would spend $5,130: the $2,000 in 401(k) and IRA statements to report fied RMD strategy does even better.

Wei Sun is an assistant professor at the Hanqing Advanced Institute of Economics at Renmin University in Beijing, China. Find
out more at www.aaii.com/authors/wei-sun. Anthony Webb is a research economist at the Center for Retirement Research at
Boston College. Find out more at www.aaii.com/authors/anthony-webb.

24 AAII Journal