Return on Equity and DuPont Analysis#

Return on Equity (ROE) measures how effectively a company generates profits from shareholders' investment. It's one of the most important metrics for assessing management effectiveness and comparing investment opportunities.

ROE = Net Income / Average Shareholders' Equity × 100%

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

Understanding ROE#

Why ROE Matters#

ROE connects profitability to shareholder investment:

Investors use it to compare returns across companies
Management is often compensated based on ROE targets
Analysts use it to assess competitive advantages
Warren Buffett considers ROE his primary profitability metric

ROE Benchmarks#

ROE Level	Interpretation
> 20%	Excellent—sustainable competitive advantage
15-20%	Strong—above cost of equity for most companies
10-15%	Average—acceptable for stable businesses
5-10%	Weak—below typical cost of equity
< 5%	Poor—destroying shareholder value

Calculating ROE#

Example:

Net Income (2023): $5 billion
Beginning Shareholders' Equity: $20 billion
Ending Shareholders' Equity: $22 billion
Average Equity: ($20B + $22B) / 2 = $21 billion
ROE = $5B / $21B = 23.8%

Use Average Equity

Since net income is earned throughout the year, using average equity (beginning + ending / 2) provides a more accurate picture than using year-end equity alone.

The DuPont Framework#

A high ROE number alone doesn't tell you how the company achieves it. The DuPont framework breaks ROE into its component parts, revealing the source of profitability.

3-Factor DuPont Analysis#

ROE = Net Profit Margin × Asset Turnover × Financial Leverage

Or: ROE = (Net Income/Revenue) × (Revenue/Assets) × (Assets/Equity)

Each component represents a different driver:

Component	Formula	What It Measures
Net Profit Margin	Net Income / Revenue	Profitability
Asset Turnover	Revenue / Total Assets	Efficiency
Financial Leverage	Total Assets / Equity	Leverage

DuPont Example#

Metric	Company A	Company B
ROE	20%	20%
Net Margin	10%	5%
Asset Turnover	1.0x	1.0x
Financial Leverage	2.0x	4.0x

Analysis: Both have 20% ROE, but Company A achieves it through profitability while Company B relies on debt. Company A's ROE is higher quality and more sustainable.

Understanding Each Component#

Net Profit Margin (Profitability)

Higher margins = more profit per sale
Reflects pricing power, cost control, and operational efficiency
Sustainable competitive advantages appear here

Asset Turnover (Efficiency)

Higher turnover = more sales per dollar of assets
Reflects how well assets are utilized
Retail and consumer typically high; utilities and REITs typically low

Financial Leverage (Risk)

Higher leverage = more assets financed by debt
Amplifies returns but also amplifies risk
Banks and financial services naturally have high leverage

The Leverage Trap

High ROE from high leverage is not the same as high ROE from strong margins. Leverage-driven ROE comes with increased bankruptcy risk and earnings volatility.

5-Factor DuPont Analysis#

For deeper analysis, the 5-factor model breaks down net margin into three components:

5-Factor ROE = Tax Burden × Interest Burden × Operating Margin × Asset Turnover × Leverage

Component	Formula	Interpretation
Tax Burden	Net Income / Pre-tax Income	Tax efficiency (higher = better)
Interest Burden	Pre-tax Income / EBIT	Debt cost impact (higher = better)
Operating Margin	EBIT / Revenue	Core profitability
Asset Turnover	Revenue / Assets	Efficiency
Financial Leverage	Assets / Equity	Leverage

5-Factor Example#

Factor	Company X	Company Y
Tax Burden	0.75	0.70
Interest Burden	0.90	0.70
Operating Margin	15%	20%
Asset Turnover	1.5x	1.5x
Leverage	2.0x	2.5x
ROE	20.3%	18.4%

Analysis: Company Y has better operating margins but pays more in interest (lower interest burden) due to higher debt. Company X's lower leverage produces similar ROE with less risk.

Interpreting High ROE#

When you see high ROE, always investigate the source:

Sustainable High ROE (Good Signs)#

Source	Example
High margins from brand power	Apple, luxury goods
Network effects	Visa, Mastercard
Switching costs	Microsoft, enterprise software
Efficient operations	Costco, Walmart

Unsustainable High ROE (Warning Signs)#

Source	Concern
Very high leverage	Increased bankruptcy risk
One-time gains	Not repeatable
Declining equity base	Share buybacks at high prices
Industry tailwinds	May reverse

The Buyback Effect#

Stock buybacks reduce equity, mechanically increasing ROE. Analyze whether:

Buybacks were at attractive prices (value creation)
Buybacks were at high prices (value destruction)
ROE growth is real or just math from lower equity

ROE Trend Analysis#

Track ROE and its components over time:

Year	ROE	Margin	Turnover	Leverage
2020	18%	12%	1.0x	1.5x
2021	20%	12%	1.0x	1.67x
2022	22%	11%	1.0x	2.0x
2023	24%	10%	1.0x	2.4x

Concern: ROE is increasing, but margins are declining. The improvement comes entirely from increased leverage—an unsustainable and risky trend.

Industry Context#

ROE norms vary by industry:

Industry	Typical ROE	Typical Leverage
Technology	15-30%	Low (1.5-2x)
Consumer Goods	15-25%	Moderate (2-3x)
Banking	10-15%	High (10-12x)
Utilities	8-12%	Moderate (2-3x)
Retail	15-25%	Moderate (2-3x)

Key Takeaways

ROE = Net Income / Average Equity—measures returns generated for shareholders
Target ROE above 15% for most industries; above 20% suggests competitive advantage
3-Factor DuPont: ROE = Margin × Turnover × Leverage
High ROE from margins indicates strength; from leverage indicates risk
5-Factor DuPont adds tax burden and interest burden for deeper analysis
Always investigate the source of high ROE—skill or leverage?
Track DuPont components over time to identify changing drivers