Decomposition of ROE is sometimes referred to as DuPont analysis because it was developed originally at that company. Decomposing ROE involves expressing the basic ratio (i.e., net income divided by average shareholders’ equity) as the product of component ratios. Because each of these component ratios is an indicator of a distinct aspect of a company’s performance that affects ROE, the decomposition allows us to evaluate how these different aspects of performance affected the company’s profitability as measured by ROE.
Analysts have developed several different methods of decomposing ROE. The decomposition presented here is one of the most commonly used and the one found in popular research databases, such as Bloomberg. Return on equity is calculated as follows:
ROE = Net income/Average shareholders’ equity.
The decomposition of ROE makes use of simple algebra and illustrates the relationship between ROE and ROA. Expressing ROE as a product of only two of its components, we can write:
which can be interpreted as follows:
ROE = ROA × Leverage.
Just as ROE can be decomposed, the individual components such as ROA can be decomposed. Further decomposing ROA, we can express ROE as a product of three component ratios:
which can be interpreted as follows:
ROE = Net profit margin × Total asset turnover × Leverage.
To separate the effects of taxes and interest, we can further decompose the net profit margin and write:
which can be interpreted as follows:
ROE = Tax burden × Interest burden × EBIT margin × Total asset turnover × Leverage.
