Basically this is the Return on Equity (ROE). However, we may not be getting the full story if we only look at ROE: net income/shareholders equity. This number is important to all investors but can be misleading. Developed in the 1920’s, the Dupont Identity allows one to breakdown ROE into a more in-depth view and see what is going on within an organization. The Dupont Identity helps to see where the movements in ROE are coming from. ROE alone tells a story about rising or falling shareholder equity. The issue arises when equity rises based on nothing more than a possible increase in debt or other number crunching possibilities.

The Dupont analysis breaks down ROE into three key components: Profit Margin, Total Asset Turnover, and Equity Multiplier. Take a look here:

ROE=(Net Income/Total Revenue)*(Total Revenue/Total Assets)*(Total Assets/Shareholder Equity)

With a little algebra (WALA!), we see that canceling out like multipliers we are left with the basic ROE = Net Income/Shareholders Equity. So why do the more detailed formulas help?

• Net Income/Total Revenue = Profit Margin.  Profit Margin gives insight into how well a company is controlling cost. Basically, for every dollar in sales, what is the profit to the bottom line of the corporation. Looking at this in comparison with direct competitors explains which company is doing a better job in cost control. So if a company has increasing sales their ROE may rise, but their cost may be increasing at a much more alarming rate. With Profit Margin we can compare this across an entire sector. Total

• Revenue/Total Assets = Asset Turnover Ratio. Asset Turnover Ratio tells of the firm’s efficiency in using assets to increase sales. The higher this number the better. Total Assets/Shareholder Equity = Equity Multiplier.

• Equity Multiplier gives a measure on the leverage of the firm. Basically, how is the company financing their assets? The higher the number indicates they are using more debt to finance the assets on hand.
  

These numbers allow an understanding of how efficient a company is running. A firm’s ROE may possibly remain unchanged for a while but with this analysis it can be determined if they are truly maintaining a good position or if some underlying fact has changed.

In the end, this is just another tool for your arsenal. ROE can tell much about a company, but closer inspection can give you an edge you may have never known existed.

To find these pieces of information check out the Financials for each security in the Quotes and Research section of the website. Net Income and Total Revenue can be found on the Income Statement. Total Assets and Shareholder Equity can be found in the Balance Sheet.

Good luck and happy trading.