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Dear Investors,
We are looking at return-on-equity. This is the second article in a series where we use finance concepts to measure and increase the value of your business.
Today, we lay the theoretical foundation on measuring business performance.
Follow along because we are going to tie all these concepts up into a framework that you can use to analyse or improve your business.
Today, we are going to measure corporate profitability using return-on-equity (ROE).
Increasing the value of your business requires you to measure its performance. There are many different profitability measures. However, return-on-equity gives us a simple, but effective way to gauge business performance.
One of the main reasons that businesses fail to improve is that they do not implement changes using a consistent framework. Return-on-equity will be the basis of our business improvement framework.
Every business owner should know their return-on-equity.
In this edition, we will look at:
What is return-on-equity?
How to separate ROE into its components, using the Du Pont formula.
How to use ROE as a performance measure.
What is return on equity?
Return-on-equity is a measure of the profitability of a business. It is calculated as follows:
ROE = Net Profit After Tax / Equity
You will find net profit after tax (NPAT) on the income statement and equity on the balance sheet.
For example, Microsoft’s 2022 ROE was:
ROE = 72 738 / 166 542
ROE = 43.7%
Du Pont analysis
In a Du Pont analysis, the return on equity formula is disaggregated. There are two versions, the three-step and five-step Du Pont analysis.
Three-step Du Pont Analysis
ROE = (Net Profit Margin) x (Asset Turnover) x (Equity Multiplier)
3-Step Du Pont Analysis
Net profit margin
Net profit margin is the ratio of profits to sales. It shows the percentage of sales that ends up as net profit.
Asset turnover
Asset turnover is the ratio of sales to total assets. It shows how efficiently assets are being used to generate revenue. The higher the asset turnover, the better.
Equity Multiplier
The equity multiplier is the ratio of total assets to equity. This is a measure of financial leverage. In other words, it shows how much debt was used to finance the purchase of assets.
Tip: I like to think about the equity multiplier by inverting it (i.e make it Equity / Total Assets). This way it shows equity as a percentage of total assets.
For example, if equity = 40 and assets = 100, then E/A = 40%. This means 40% of the assets purchased were financed with equity and the remaining 60% was financed with debt.
I learned this from the legendary money manager, Peter Lynch. He calls the equity-to-assets ratio, the most fundamental measure of financial strength.
The higher the ratio, the less debt has been used. This reduces the chance of the business going bankrupt. For example, if equity = 100 and assets = 100, then the E/A = 100%. This means that all assets are equity financed and the business cannot go bankrupt because it owes no money.
Five-step Du Pont Analysis:
The five-step Du Pont formula breaks the equation down into more components. In this case, EBIT is Earnings Before Interest and Tax. The main difference here is that the net profit margin has been split into three terms. The first term shows the tax burden, the second term shows the interest burden and the third term shows the operating margin. The fourth and fifth term remain the same as the 3-Step Du Pont analysis.
5-Step Du Pont Analysis
All versions of the Du Pont analysis should give the same answer.
Using ROE as a performance measure
You can use ROE to measure business performance as follows:
You can compare ROE from year-to-year in your own business. This will show if your business is improving or not.
You can compare ROE to the cost-of-equity (see last week’s newsletter). This will show if your business is delivering an adequate return.
You can compare ROE from one business to another (do this with care as each business may be financed differently).
From the table, we can see that Microsoft has a high return-on-equity which peaked at around 43.7% last year. It has dropped slightly since then. Microsoft has a cost-of-equity of approximately 10.37%. The return-on-equity is higher than the cost-of-equity (ROE > COE), which means that Microsoft is earning more than sufficient return.
Conclusion
Return-on-equity is a commonly used profitability measure. It is easily calculated from accounting information and it can be broken down into components. All of this makes it a very useful measure.
If you can improve the return-on-equity in your business from year-to-year and keep it above the cost-of-equity, you will be well on your way to increasing your business’ value.
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