Financial Education

Return on equity is one of the most significant financial ratios. Not only does it describe how well management is making use of the funds it has been entrusted with, but it also sets the limits of sustainable growth. Analysts at DuPont created a system to analyze the components of ROE to better understand how the return is being generated.

The basic formula for ROE is net income divided by shareholders equity. This, in turn, can be recast into two components - the return on assets and the impact of leverage.

(Net income/Shareholders equity) = (Net income)/(Total Assets) X (Total assets)/(Shareholders equity).

ROA can also be expressed as a function of profit margin and asset turnover: (Net income)/(Total assets) = (Net income)/Sales X Sales/(Total assets) and thus ROE = (Net income)/Sales X Sales/(Total assets) X (Total assets)/(Shareholders equity).

For more information, see all articles on: Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis

See also:

A Two Stage Dividend Discount Model With Constant First-Stage Growth

Multi-Stage Dividend Discount Models

A Three Stage H-Model Dividend Discount Model

Using the Market Price to Calculate Implicit Return in a Multi-Stage Dividend Discount Model

Using the Single Stage Residual Model to Calculate Implied Expected Growth