Many equity investors look into return on equity for judging whether company is generating good return on the investment of the shareholders. However it may not be prudent to look at ROE, instead one should go for DuPont analysis in order to have a better understanding about the return on equity.
DuPont can be calculated as ROE = (net income / sales) * (sales / assets) * (assets / shareholder’s equity)
In the above equation we have ROE broken down into net profit margin which implies that how much profit the company is earning from sales, asset turnover which implies that how efficiently the company is using its assets, and equity multiplier which is a measure of how much the company is leveraged.
If a company’s ROE goes up due to an increase in the net profit margin or asset turnover, it is a positive sign for the company. However, if the ROE is increasing due to equity multiplier, it may not be a good sign indicating that company ROE is increasing due to excess leverage.
Even if a company’s ROE has remained unchanged, assessment in this way can be very helpful. Suppose a company’s net profit margin and asset turnover decreased, that implies that ROE stayed the same due to a large increase in equity multiplier or leverage which is not a good sign for a company.