Saturday 24 May 2014

DuPont Analysis - Dissecting ROE

  • Return of Equity (ROE) reveal how much the company is making compared with how much it has invested to make that. 
    • ROE = Net Inome / Equity
  • It is one of the most important indicators of a firm’s profitability and potential growth
  • Companies that boast a high ROE with little or no debt are able
    • to grow without large capital expenditures
    • allowing the owners of the business to withdrawal cash and reinvest it elsewhere
  •  DuPont equation
    • ROE = Net Income/Equity 
      • = Net Income/Sales * Sales/Total Assets * Total Assets / Equity -
        The sales and total asset on the right side of the equation negate each other, seeing as one is in the numerator and one is in the denominator
      • = Net Income Margin * Asset Turn Over * Financial Leverage
    • It tells where a company's strength lies and where there is room for improvement
    •  A firm can achieve higher ROE if
      • Higher Net Income Margin & asset turn over
      • Increase Financial Leverage  - when times are good, leverage amplifies ROE, but in bad times, it can hurt ROE badly. And, too much leverage can make a company becoming risky in time of economic downturn and financial crisis.
  • It is important to look at the long-term trend in ROE to make sure that it is not steadily declining significantly.
  • One must be aware about the economic cycles and that when a company grows bigger, it is harder to continue improving its ROE which is already high. 

References:-

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