Return on Equity Definition
ROE is the short form used for Return on Equity and it can be defined as a measure used to evaluate the ROR (also known as rate of return) that the equity holders are entitled to receive and it even indicates how good an organization has been performing with respect to generating ROI or returns on investment that it received from its equity holders.
We note from the above chart that ROE of Pepsi is better than that of Coca-Cola. Why?
In order to answer this question, most analysts use Dupont Return on Equity formula and find out Profit Margin, Asset Turnover and Equity Multiplier (Financial Leverage). But how they are connected and why does it matters?
Return on Equity Formula
We will look at the whole formula.
First, let’s look at the formula of Return on Equity –
Return on Equity = Net Income / Total Equity
If we look at ROE in a different way, we will get this –
DuPont ROE = (Net Income / Net Sales) x ( Net Sales / Total Assets) x Total Assets / Total Equity
DuPont Return on Equity = Profit Margin * Total Asset Turnover * Equity Multiplier
Now you can understand that they all are separate ratios. If you are wondering how come we have come to the conclusion that if we multiply these three ratios we will get a return on equity, here’s how we have reached the conclusion.
- Profit Margin = Net Income / Net Sales
- Total Asset Turnover = Net Sales / Average Total Assets (or Total Assets)
- Equity Multiplier = Total Assets / Total Equity
Now, let’s put them together and see whether we get the return on equity or not –
(Net Income / Net Sales * Net Sales / Average Total Assets * Total Assets / Total Equity
If we look closely, we will see that by multiplying all these three ratios, we end up with just Net Income / Total Equity.
So we come to the conclusion that if we use these three ratios and multiply them we would get Return on Equity.
Interpretation
ROE is always useful. But to those investors who want to find out the “why” behind the current ROE (high or low), they need to use DuPont analysis to pinpoint where is the actual problem lies and where the firm has done well in.
In the DuPont model, we can look at three separate ratios by comparing which they can come to the conclusion whether it’s wise for them to invest in the company or not.
For example, if inequity multiplier if we find out that the firm is more dependent on the debt rather than equity, we may not invest in the company because that may become a risky investment.
On the other hand, by using this DuPont model you would be able to pare down the chances of losses by looking at profit margin and asset turnover and vice versa.
ROE Example
In this section, we will take two examples of Return on Equity. The first example is the easier one and the second example would be a bit complex.
Let’s jump in and see the examples right away.
Example # 1
Let’s look at two firms A and B. Both of these companies operate in the same apparel industry and most astonishingly both of their Return on Equity (ROE) is 45%. Let’s look at the following ratios of each company so that we can understand where the problem lies (or opportunity) –
| Ratio | Firm A | Firm B |
| Profit Margin | 40% | 20% |
| Total Asset Turnover | 0.30 | 5.00 |
| Equity Multiplier | 5.00 | 0.60 |
Now let’s look at each of the firms and analyze.
For Firm A, the profit margin is great, i.e. 40% and the financial leverage is also quite good, i.e. 4.00. But if we look at the total asset turnover, it’s much less. That means Firm A is not able to utilize its assets properly. But still, due to the other two factors, the Return on Equity is higher (0.40 * 0.30 * 5.00 = 0.60).
For Firm B, the profit margin is much lower, i.e. just 20% and the financial leverage is very poor i.e. 0.60. But the total asset turnover is 5.00. Thus, for higher asset turnover, Firm B has performed well in the overall sense of Return on Equity (0.20 * 5.00 * 0.60 = 0.60).
Now imagine what would happen if the investors would only look at the Return on Equity of both these firms, they would only see that the ROE is quite good for both of the firms. But after doing DuPont analysis, the investors would get the actual picture of both of these firms.
Example # 2
At the of the year, we have these details about two companies –
| In US $ | Company X | Company Y |
| Net Income | 15,000 | 20,000 |
| Net Sales | 120,000 | 140,000 |
| Total Assets | 100,000 | 150,000 |
| Total Equity | 50,000 | 50,000 |
Now if we directly calculate the ROE from the above information, we would get –
| In US $ | Company X | Company Y |
| Net Income (1) | 15,000 | 20,000 |
| Total Equity (2) | 50,000 | 50,000 |
| Return on Equity (1 / 2) | 0.30 | 0.40 |
Now using the DuPont Analysis, we would look at each of the components (three ratios) and find out the real picture of both of these companies.
Let’s calculate the profit margin first.
| In US $ | Company X | Company Y |
| Net Income (3) | 15,000 | 20,000 |
| Net Sales (4) | 120,000 | 140,000 |
| Profit Margin (3 / 4) | 0.125 | 0.143 |
Now, let’s look at total asset turnover.
| In US $ | Company X | Company Y |
| Net Sales (5) | 120,000 | 140,000 |
| Total Assets (6) | 100,000 | 150,000 |
| Total Asset Turnover (5 / 6) | 1.20 | 0.93 |
We will now calculate the last ratio i.e. financial leverage of both the companies.
| In US $ | Company X | Company Y |
| Total Assets (7) | 100,000 | 150,000 |
| Total Equity (8) | 50,000 | 50,000 |
| Financial Leverage (7 / 8) | 2.00 | 3.00 |
Using DuPont analysis, here’s the ROE for both of the companies.
| In US $ | Company X | Company Y |
| Profit Margin (A) | 0.125 | 0.143 |
| Total Asset Turnover (B) | 1.20 | 0.93 |
| Financial Leverage (C) | 2.00 | 3.00 |
| Return on Equity (DuPont) (A*B*C) | 0.30 | 0.40 |
If we compare each of the ratios, we would be able to see the clear picture of each of the companies. For Company X and Company Y, financial leverage is the strongest point. For both of them, they have a higher ratio in financial leverage. In the case of profit margin, both of these companies have a lesser profit margin, even less than 15%. The asset turnover of Company X is much better than Company Y. So when investors would use DuPont, they would be able to understand the pressing points of the company before investing.
Calculate Return on Equity of Nestle
Let’s look at the income statement and balance sheet of Nestle and then we will calculate the ROE and ROE using DuPont.
Consolidated income statement for the year ended 31st December 2014 & 2015
Consolidated balance sheet as at 31st December 2014 & 2015
Source: Nestle.com
- ROE = Net Income / Sales
- Return on Equity (2015) = 9467 / 63986 = 14.8%
- Return on Equity (2014) = 14904 / 71,884 = 20.7%
Now we would use DuPont analysis to calculate Return on Equity for 2014 and 2015.
| In millions of CHF | 2015 | 2014 |
| Profit for the year (1) | 9467 | 14904 |
| Sales (2) | 88785 | 91612 |
| Total assets (3) | 123992 | 133450 |
| Total Equity (4) | 63986 | 71884 |
| Profit Margin (A = 1/2) | 10.7% | 16.3% |
| Total Asset Turnover (B = 2/3) | 0.716x | 0.686x |
| Equity Multiplier (C = 3/4) | 1.938x | 1.856x |
| Return on Equity (A*B*C) | 14.8% | 20.7% |
As we note from above that basic ROE formula and DuPont Formula provides us with the same answer. However, DuPont analysis helps us in analyzing the reasons why there was an increase or decrease in ROE.
For example, for Nestle, Return on Equity decreased from 20.7% in 2014 to 14.8% in 2015. Why?
DuPont Analysis helps us find out the reasons.
We note that Nestle’s Profit Margin for 2014 was 16.3%, however, it was 10.7% in 2015. We note that this is a huge dip in profit margin.
Comparatively, if we look at other components of DuPont, we do not see such substantial differences.
- Asset Turnover was 0.716x in 2015 as compared to 0.686x in 2014
- Equity Multiplier was at 1.938x in 20.15 as compared to 1.856x in 2014.
There we conclude that the decrease in profit margin has led to the reduction of ROE for Nestle.
Colgate’s ROE calculation
Now that we know how to calculate Return on Equity from Annual Filings, let us analyze the ROE of Colgate and identify reasons for its increase/decrease.
Return on Equity Calculation of Colgate
Below is a snapshot of the Colgate Ratio Analysis Excel Sheet. You can download this sheet from Ratio Analysis Tutorial. Please note that in Colgate’s calculation of ROE, we have used Average Balance Sheet numbers (instead of year-end).
Colgate Return on Equity has remained healthy in the last 7-8 years. Between 2008 to 2013, ROE was around 90% on average.
In 2014, Return on Equity was at 126.4% and in 2015, it jumped significantly to 327.2%.
This has happened despite a 34% decrease in Net Income in 2015. Return on Equity jumped significantly because of the decrease in Shareholder’s
Equity in 2015. Shareholder’s equity decreased due to share buyback and also because of accumulated losses that flow through the Shareholder’s Equity.
DuPont ROE of Colgate
Colgate Dupont Return on Equity = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Shareholder’s Equity). Here please note that the Net Income is after the minority shareholder’s payment. Also, the shareholder’s equity consists of only the common shareholders of Colgate.
We note that the asset turnover has shown a declining trend over the past 7-8 years. Profitability has also declined over the past 5-6 years
However, ROE has not shown a declining trend. It is increasing overall. This is because of the Equity Multiplier (total assets / total equity). We note that the Equity Multiplier has shown a steady increase over the past 5 years and is currently stands at 30x.
ROE of Soft Drink Sector
Let us have a look at the ROE’s of Top Soft Drink companies. Details provided here is the Market Capitalization, ROE, Profit Margin, Asset Turnover, and Equity Multiplier.
| Name | Market Cap ($ million) | Return on Equity (Annual) | Profit Margin (Annual) | Asset Turnover | Equity Multiplier |
|---|---|---|---|---|---|
| Coca-Cola | 180454 | 26.9% | 15.6% | 0.48x | 3.78x |
| PepsiCo | 158977 | 54.3% | 10.1% | 0.85x | 6.59x |
| Monster Beverage | 26331 | 17.5% | 23.4% | 0.73x | 1.25x |
| Dr Pepper Snapple Group | 17502 | 39.2% | 13.2% | 0.66x | 4.59x |
| Embotelladora Andina | 3835 | 16.9% | 5.1% | 1.19x | 2.68x |
| National Beverage | 3603 | 34.6% | 8.7% | 2.31x | 1.48x |
| Cott | 1686 | -10.3% | -2.4% | 0.82x | 4.54x |
source: ycharts
- Overall, Soft Drink sectors demonstrate a healthy ROE (more than 25% on average).
- We note that PepsiCo is the best in this group with a Return on Equity of 54.3%, while Coca-Cola has an ROE of 26.9%
- Profit Margin of Coca-Cola is at 15.6% as compared to PepsiCo’s profit margin of 10.1%. Even though PepsiCo’s profit margin is lower, its Asset turnover and Equity Multiplier are almost twice of that of Coca-Cola. This results in an increased ROE for PepsiCo.
- Cott is the only company in this group with negative Return on Equity as it’s profit margin is -2.4%
Return on Equity of Automobile Sector
Below is the list of Top automobile companies with Market Capitalization, ROEs, and Dupont ROE breakup.
| Name | Market Cap ($ million) | Return on Equity (Annual) | Profit Margin (Annual) | Asset Turnover | Equity Multiplier |
|---|---|---|---|---|---|
| Toyota Motor | 167658 | 13.3% | 8.1% | 0.56x | 2.83x |
| Honda Motor Co | 55943 | 4.8% | 2.4% | 0.75x | 2.70x |
| General Motors | 54421 | 22.5% | 5.7% | 0.75x | 5.06x |
| Ford Motor | 49599 | 15.9% | 3.0% | 0.64x | 8.16x |
| Tesla | 42277 | -23.1% | -9.6% | 0.31x | 4.77x |
| Tata Motors | 24721 | 14.6% | 3.6% | 1.05x | 3.43x |
| Fiat Chrysler Automobiles | 21839 | 10.3% | 1.6% | 1.11x | 5.44x |
| Ferrari | 16794 | 279.2% | 12.8% | 0.84x | 11.85x |
source: ycharts
- Overall, Automobile Sectors have lower ROE’s as compared to that of Soft Drink Sector (average ROE is around 8% excluding outliers)
- We note that Ferrari shows a significantly higher ROE (279%) as compared to that of its peer group. This is because of higher profitability (~12.8%) and a very high Equity Multiplier (11.85x)
- General Motors has an ROE of 22.5%, while Ford has an ROE of 15.9%
- Tesla has a Negative ROE as it is still loss-making (profit margin of -9.6%)
ROE of Discount Stores
The below table provides a snapshot of Top Discount stores along with their Return on Equity, Market Cap, and Dupont breakup.
| Name | Market Cap ($ million) | Return on Equity (Annual) | Profit Margin (Annual) | Asset Turnover | Equity Multiplier |
|---|---|---|---|---|---|
| Wal-Mart Stores | 214785 | 17.2% | 2.8% | 2.44x | 2.56x |
| Costco Wholesale | 73659 | 20.7% | 2.0% | 3.58x | 2.75x |
| Target | 30005 | 22.9% | 3.9% | 1.86x | 3.42x |
| Dollar General | 19982 | 23.2% | 5.7% | 1.88x | 2.16x |
| Dollar Tree Stores | 17871 | 18.3% | 4.3% | 1.32x | 2.91x |
| Burlington Stores | 6697 | -290.1% | 3.9% | 2.17x | -51.68x |
| Pricesmart | 2832 | 14.7% | 3.1% | 2.65x | 1.72x |
| Big Lots | 2228 | 22.3% | 2.9% | 3.23x | 2.47x |
| Ollie's Bargain Outlet | 1970 | 7.3% | 4.7% | 0.81x | 1.68x |
source: ycharts
- Overall, Discount Stores have an average Return on Equity of approximately 18% (less than Soft Drink companies ROE, but more than the Automobile sector ROEs)
- Discount Store sector has a lower profit margin (less than 4%) and higher asset turnover and Equity Multiplier
- Wal-Mart Stores have an ROE of 17.2% as compared to that of Targets’ Return on Equity of 22.9%.
ROE of Engineering & Construction
The below table provides us with a list of top Engineering & Construction companies along with their Market Capitalization, ROEs, and Dupont ROE breakup.
| Name | Market Cap ($ million) | Return on Equity (Annual) | Profit Margin (Annual) | Asset Turnover | Equity Multiplier |
|---|---|---|---|---|---|
| Fluor | 7465 | 13.5% | 2.3% | 2.37x | 2.55x |
| Jacobs Engineering Group | 6715 | 4.9% | 1.9% | 1.49x | 1.73x |
| AECOM | 5537 | 2.8% | 0.6% | 1.27x | 4.08x |
| Quanta Services | 5408 | 6.2% | 2.6% | 1.43x | 1.60x |
| EMCOR Group | 3794 | 12.1% | 2.4% | 1.94x | 2.53x |
| MasTec | 3249 | 12.9% | 2.6% | 1.61x | 2.90x |
| Chicago Bridge & Iron | 2985 | -18.3% | -2.9% | 1.36x | 5.55x |
| Dycom Industries | 2939 | 24.2% | 4.8% | 1.55x | 3.09x |
| Stantec | 2922 | 8.2% | 3.0% | 1.02x | 2.17x |
| Tetra Tech | 2270 | 9.7% | 3.2% | 1.43x | 2.07x |
| KBR | 2026 | -6.7% | -1.4% | 1.03x | 5.47x |
| Granite Construction | 1940 | 7.4% | 2.6% | 1.46x | 1.94x |
| Tutor Perini | 1487 | 6.4% | 1.9% | 1.23x | 2.60x |
| Comfort Systems USA | 1354 | 17.9% | 4.0% | 2.31x | 1.88x |
| Primoris Services | 1224 | 5.5% | 1.3% | 1.71x | 2.35x |
source: ycharts
- Overall, ROE of Engineering & Construction companies is on the lower side (Average ROE of approx. 7.1%
- Dycom industries have a higher ROE in the group primarily due to higher Profit Margin (4.8% as compared to an average profit margin of 1.9% of the group).
- Chicago Bridge & Iron has a negative ROE of -18.3% as it is loss-making with a profit margin of -2.9%
ROE of Internet Companies
Below is the list of Top Internet and content companies’ ROE with Market Cap and other Dupont return on equity breakup
| Name | Market Cap ($ million) | Return on Equity (Annual) | Profit Margin (Annual) | Asset Turnover | Equity Multiplier |
|---|---|---|---|---|---|
| Alphabet | 603174 | 15.0% | 21.6% | 0.54x | 1.20x |
| 404135 | 19.8% | 37.0% | 0.43x | 1.10x | |
| Baidu | 61271 | 13.6% | 16.5% | 0.40x | 1.97x |
| JD.com | 44831 | -12.1% | -1.5% | 1.69x | 4.73x |
| Yahoo! | 44563 | -0.7% | -4.1% | 0.11x | 1.55x |
| NetEase | 38326 | 34.9% | 30.4% | 0.69x | 1.52x |
| 10962 | -10.2% | -18.1% | 0.37x | 1.49x | |
| 10842 | 15.7% | 16.5% | 0.63x | 1.38x | |
| VeriSign | 8892 | -38.8% | 38.6% | 0.49x | -1.94x |
| Yandex | 7601 | 9.2% | 9.0% | 0.60x | 1.48x |
| Momo | 6797 | 3.0% | 26.3% | 1.02x | 1.16x |
| GoDaddy | 6249 | -3.3% | -0.9% | 0.49x | 6.73x |
| IAC/InterActive | 5753 | -2.2% | -1.3% | 0.68x | 2.49x |
| 58.com | 5367 | -4.4% | -10.3% | 0.31x | 1.43x |
| SINA | 5094 | 8.6% | 21.8% | 0.24x | 1.60x |
source: ycharts
- Overall, ROE’s of Internet and Content companies varies a lot.
- We note that the Alphabet (Google) has an ROE of 15%, while that of Facebook is 19.8%
- There are many stocks in the table that have Negative ROE like JD.com (ROE of -12.1%), Yahoo (-0.7%), Twitter (-10.2%), Verisign (-38.8%), Godaddy (-3.3%), etc. All these stock exhibits negative ROE because they are loss-making companies.
Return on Equity of Oil & Gas Companies
Below is the list of Top Oil & Gas companies with their ROE.
| S. No | Name | Market Cap ($ million) | Return on Equity (Annual) | Profit Margin (Annual) | Asset Turnover | Equity Multiplier |
|---|---|---|---|---|---|---|
| 1 | ConocoPhillips | 56465 | -9.7% | -14.8% | 0.27x | 2.57x |
| 2 | EOG Resources | 55624 | -8.1% | -14.3% | 0.26x | 2.11x |
| 3 | CNOOC | 52465 | 5.3% | 11.8% | 0.27x | 1.72x |
| 4 | Occidental Petroleum | 48983 | -2.5% | -5.5% | 0.23x | 2.01x |
| 5 | Canadian Natural | 36148 | -0.8% | -1.9% | 0.18x | 2.23x |
| 6 | Anadarko Petroleum | 35350 | -24.5% | -39.0% | 0.19x | 3.73x |
| 7 | Pioneer Natural Resources | 31377 | -5.9% | -14.5% | 0.24x | 1.58x |
| 8 | Devon Energy | 21267 | -101.1% | -110.0% | 0.43x | 4.18x |
| 9 | Apache | 19448 | -19.9% | -26.2% | 0.24x | 3.61x |
| 10 | Concho Resources | 19331 | -20.1% | -89.4% | 0.13x | 1.59x |
| 11 | Continental Resources | 16795 | -7.3% | -13.2% | 0.17x | 3.20x |
| 12 | Hess | 15275 | -36.2% | -126.6% | 0.17x | 1.97x |
| 13 | Noble Energy | 14600 | -10.2% | -28.6% | 0.16x | 2.26x |
| 14 | Marathon Oil | 13098 | -11.9% | -46.0% | 0.14x | 1.77x |
| 15 | Cimarex Energy | 11502 | -16.7% | -34.3% | 0.27x | 1.98x |
source: ycharts
- We note that all Oil & Gas companies listed in the table have a negative Return on Equity.
- This is primarily due to loss these companies are making since 2013 due to a slowdown in the commodities cycle (Oil).
Limitations of ROE
Even if it seems that DuPont Analysis has no limitations, there are a couple of limitations of DuPont Analysis. Let’s have a look –
- There are so many inputs to be fed. So if there is one error in the calculation, the whole thing would go wrong. Moreover, the source of information also needs to be reliable. The wrong calculation means a wrong interpretation.
- Seasonal factors should also be taken into consideration in terms of calculating the ratios. In case of DuPont Analysis, the seasonal factors should be taken into account which most of the time aren’t possible.
