The Dupont Equation, first used as a measure of corporate health by the Dupont Corporation in the 1920s, is in my opinion one of the best ways to understand what drives Return on Equity. The abridged version is written as follows.
Return on Equity = Net Income / Shareholder Equity.
Return on Equity = (Net Income / Sales) * (Sales / Total Assets) * (Total Assets / Shareholder Equity).
This is equivalent to saying –
Return on Equity = Net Margin * Asset Turnover * Financial Leverage.
Implication 1: A company can improve its Return on Equity in the following ways
(1) Improving its margins i.e ensuring more of revenue from the top-line is reaching the bottom-line.
(2) Improving the efficiency in which it uses its assets by generating more Rs of Sales per Rs of Assets used.
(3) Increasing the amount of debt financing it takes on, relative to equity.
Now while (1) and (2) are desirable, (3) is not unless you have a really low cost of borrowing. While in theory it would you could inflate your ROE this way, debt has a real cost which will show up on the income statement in terms of interest expenses, thereby lowering net margins. Interest expense also implies higher tax deductions, so this must also be taken into account.
Thus, in order to adjust for the impact of debt financing and tax implications on ROE, there is a revised ROE equation
Return on Equity = (Net Income / Pre-tax Income)*(Pre-tax Income / Earnings Before Interest & Taxes) * (Earnings before Interest & Taxes / Sales) * (Sales / Total Assets) * (Total Assets / Shareholder Equity)
Return on Equity = Tax burden * Interest Burden * Operating Margin * Asset Turnover * Financial Leverage
In looking at whether a company’s ROE and seeing whether it is increasing or decreasing, the Dupont Equation is thus a powerful tool to break it down into pieces and understand what the drivers of ROE are.
Considering a real life example of Dabur India
While the drop in ROE looks alarming, a closer inspection at the Dupont Equation allows us to gauge that the drop is due to Dabur reducing its financial leverage from 1.74 to 1.22 (You can verify this by checking the reduction in the Debt to Equity ratio). It is a good example of how leverage can make ROE look inflated, however if the company borrows too much it may not be able to make its interest payments during bad times.
Disclaimer: No position in Dabur at the time of writing this post, nor is this a recommendation to buy the stock. Just used it as an example.