Deconstructing ROE: The 3-Step Dupont Model#

Two companies both report 20% ROE. You might think they're equally good investments. But one achieves that return through brilliant products with premium pricing, while the other uses dangerous amounts of debt to juice returns. The Dupont Analysis reveals which is which.

Why ROE Alone Is Misleading#

Return on Equity (ROE) is calculated as:

ROE = Net Income / Shareholders' Equity

It answers: "For every dollar shareholders have invested, how much profit did the company generate?"

The Problem: A company can boost ROE in three completely different ways:

1. Earn higher profits on each sale (the good way)
2. Sell more efficiently with fewer assets (also good)
3. Borrow heavily to amplify returns (risky)

Without decomposition, you can't tell which lever a company is pulling.

The 3-Step Dupont Formula#

The Dupont model breaks ROE into three multiplicative components:

Notice how the terms cancel out to give you Net Income / Equity—the original ROE formula.

Component 1: Net Profit Margin (Profitability)#

Formula: Net Income / Revenue

What it measures: How much of each dollar of sales becomes profit after all expenses.

Strategic meaning: Companies with high margins have pricing power—customers will pay premium prices for their products. This typically comes from strong brands, patents, or unique capabilities.

Real Example—Apple (2024):

• Revenue: $383 billion
• Net Income: $97 billion
• Net Margin: $97B / $383B = 25.3%

Apple keeps 25 cents of profit from every dollar of sales—exceptional pricing power from brand loyalty and ecosystem lock-in.

Component 2: Asset Turnover (Efficiency)#

Formula: Revenue / Total Assets

What it measures: How efficiently a company uses its assets to generate sales. Higher is better.

Strategic meaning: Companies with high asset turnover run lean operations—they don't tie up capital in inventory, equipment, or facilities unnecessarily.

Real Example—Walmart (2024):

• Revenue: $648 billion
• Total Assets: $253 billion
• Asset Turnover: $648B / $253B = 2.56x

Walmart generates $2.56 in sales for every $1 of assets—they move inventory fast and don't waste capital on idle resources.

Component 3: Financial Leverage (Risk/Amplification)#

Formula: Total Assets / Shareholders' Equity

What it measures: How much the company relies on borrowed money (debt) versus shareholder capital.

Strategic meaning: Leverage amplifies returns—both good and bad. A company with 3x leverage makes 3x the return on equity for a given return on assets, but also faces 3x the bankruptcy risk if things go wrong.

Real Example—JPMorgan Chase (2024):

• Total Assets: $3.9 trillion
• Shareholders' Equity: $327 billion
• Leverage: $3.9T / $327B = 11.9x

Banks operate with extreme leverage because their "debt" is customer deposits. This is normal for the industry but would be dangerous for a retailer.

Complete Dupont Calculation: Three Real Companies#

Let's apply the full Dupont framework to three different business models:

Apple (Premium Technology)#

Wait, 157%? Apple's ROE is astronomically high because of massive share buybacks that reduced equity. Their actual TTM ROE is around 147%. This illustrates why leverage must be understood in context—Apple's "leverage" includes returns to shareholders, not risky debt.

Walmart (High-Volume Retail)#

Walmart's strategy: Razor-thin margins (2.4%) compensated by incredible asset efficiency (2.56x turnover). Moderate leverage.

JPMorgan Chase (Financial Services)#

Banks have high margins and extreme leverage but very low asset turnover (assets = loans, which generate interest slowly).

Step-by-Step Real Example: Costco (COST)#

Let's walk through a complete 3-Step Dupont Analysis using Costco—a fascinating case because it achieves excellent ROE with razor-thin margins.

Step 1: Gather Financial Data#

First, retrieve the key numbers from Costco's latest annual report (FY 2024):

Step 2: Calculate Net Profit Margin#

Formula: Net Income ÷ Revenue

Net Profit Margin = $7.4B ÷ $254.5B = 2.9%

Interpretation: Costco keeps less than 3 cents of profit from every dollar sold. This is intentionally low—they pass savings to customers through low prices, creating extreme loyalty.

Step 3: Calculate Asset Turnover#

Formula: Revenue ÷ Total Assets

Asset Turnover = $254.5B ÷ $69.8B = 3.65x

Interpretation: Costco generates $3.65 in sales for every $1 of assets. This is exceptional—it means their warehouses, inventory, and equipment are incredibly productive. They achieve this through:

• Limited SKUs (only ~4,000 vs. 30,000+ at supermarkets)
• High-volume bulk sales
• Fast inventory turnover
• Membership model that ensures consistent traffic

Step 4: Calculate Financial Leverage#

Formula: Total Assets ÷ Shareholders' Equity

Financial Leverage = $69.8B ÷ $23.6B = 2.96x

Interpretation: Costco uses moderate leverage—about $3 of assets for every $1 of equity. This is reasonable for a retailer with stable cash flows from membership fees.

Step 5: Verify ROE#

Formula: Net Margin × Asset Turnover × Leverage

ROE = 2.9% × 3.65 × 2.96 = 31.3%

Verification: Check against the direct calculation:

Direct ROE = Net Income ÷ Equity = $7.4B ÷ $23.6B = 31.4%

The small difference (31.3% vs. 31.4%) is due to rounding—our Dupont calculation is correct!

Step 6: Interpret the Results#

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Try It Yourself#

Practice calculating Dupont components with real stock data. Compare retailers (Costco, Walmart, Target) to see how different strategies produce ROE:

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Comparison: Same ROE, Different Quality#

Now imagine three hypothetical companies all with 15% ROE:

Analysis:

• LuxuryBrand Co.: High-quality ROE driven by pricing power (15% margin). No debt needed. Sustainable.
• FastRetail Inc.: Good ROE driven by operational efficiency (2.5x turnover). Moderate leverage is manageable.
• DebtLoad Corp.: Low margins, low efficiency, but uses 5x leverage to manufacture a 15% ROE. If revenue drops 10%, they could face bankruptcy.

How to Use Dupont Analysis in Practice#

Step 1: Calculate the Components#

For any company you're analyzing, pull these numbers from financial statements:

• Net Income (Income Statement)
• Revenue (Income Statement)
• Total Assets (Balance Sheet)
• Shareholders' Equity (Balance Sheet)

Step 2: Compare to Industry Peers#

Step 3: Track Trends Over Time#

Step 4: Assess ROE Quality#

Industry Benchmarks#

Use these as starting points for comparison:

Common Mistakes to Avoid#