Monday, February 18, 2008

Dupont analysis of ROE

One metric that I really find it helpful to analysis in detail is actually the ROE - returns on equities. The definition of ROE:

ROE = Net earnings/total equities

Problem with metrics such as these is that the definition can be tweaked accordingly to one's needs. Net earnings can be trailing (past 12 months) or forward looking. As such, it's important to make sure that the components that make up ROE is defined clearly, otherwise we might not be comparing apples to apples.

One system which helps me to understand the interaction of ratios is actually the Dupont system. Dupont system of analysing ROE splits it up into 3 parts, all multiplied together to derive the ROE.

ROE = Financial leverage x Assets turnover x Net margin

Financial leverage = Assets / equity
- financial leverage measures the total assets that a company have (like bond issues, bank loans, accounts payable etc) to the equities. Basically the higher this ratio is, the more debts that the company has.

Assets turnover = Revenues/Assets
- Asset turnover measures how much revenue is generated for each dollar of assets. Some business need a certain amount of assets before revenue can be generated (e.g. utilities) while others need less amount of assets input (e.g. software). Basically, the higher this ratio, the more productive the firm will be in terms of generating revenue from their assets. You can see this ratio as how fast the assets are churning out revenue too.

Net margin = Profits after tax/Revenues
- Revenue is the dollar amount received from selling goods or services. But not all will go into the coffers, some of them will need to pay for the expenditures. Hence, this ratio will tell us how many dollars is made upon a dollar of revenue earned. The higher this ratio is, the more profitable the revenue stream is.

The more interesting part of Dupont analysis is that, if you do a little algebra, the components of adjacent ratios will cancel each other out, giving us the ROE exactly.

ROE = (Assets /equity) x (Revenues/Assets) x (Profits/Revenues)

Thus by breaking up ROE into 3 components, we can see what really drives the ROE of a company. Is it the high leverage of the company that creates higher ROE, or high margins, or high asset turnover?

Most of the information is courtesy Shares Investment and from DBS vickers online Clarity service. I didn't double check the information, so if you're wondering why dairy farm have a ROE of over 1000%, well, me too! Please double check the information, I'm not responsible for any wrong information provided :)

It's interesting to look at Swiber and china milk, very similar ROE. We can see that both Swiber and Chinamilk have similar financial leverage. Asset turnover for Swiber is the thing that causes the ROE to be high, which shows that Swiber did pretty good use of its assets in generating revenue. China milk, on the other hand, banks on its high net margins to drive ROE. This means that China milk is sitting on a very profitable business, with 86 cts of net profit coming from every $1 in revenue.

Dupont analysis thus allows us to analyse what drives the ROE. Is it financial leverage, high turnover or high margins that push ROE high? For more details, of course, there is no escaping poring through the financial statements. But I think this forms a pretty good start.


Investopenly said...

Nice breakdown of ROE! Thanks.