1.3.2 DuPont Method

1.3.2 DuPont Method

Individuals will differ on their preferred ratio – and that’s ok. But we’re going to give one answer here that we think is particularly useful.

The DuPont Framework

The DuPont Framework provides a way to think about the drivers of ROE.

 

Return on Equity (ROE)

=

Profitability

Profit Margin

Net Income


Sales

X

Efficiency

Asset Turnover

Sales


Assets

X

Leverage

Leverage

Assets


Equity

In short, the DuPont Framework tells us that there are only three ingredients to an ROE: profitability as measured by Profit Margin, efficiency as measured by Asset Turnover, and leverage as measured by the Leverage Ratio, as shown above.

Is ROE the Perfect Ratio?

As we discussed, people disagree about the best ratio. There are no silver bullets.  We’ve talked about some advantages of ROE. What do you think are some of its flaws, and what alternatives do we have?

There are at least two problems with ROE.  First, because it includes the effects of leverage, it does not purely measure operational performance.  Second, as we’ll see later, it does not correspond to the cash generating capability of a business. We’ll return to both of those ideas later.