Return on Equity

ROE = Net Income / Total Owners Equity

ROE measures the effectiveness of equity capital deployment. This is what the owners earn.

The DuPont Analysis framework breaks down ROE into three value drivers which are component ratios:

ROE = $\frac{\text{Net income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Total assets}}\times \frac{\text{Total assets}}{\text{Total equity}}$

Operating Efficiency

Measured by the ratio of net income to sales i.e $\frac{\text{Net income}}{\text{Sales}}$

• & "How efficient is management in converting a dollar of sales to a dollar of income?"

Hence, to increase operating efficiency, we have to increase revenue or reduce expenses (COGS, OpEx, IntEx, Taxes).

Companies selling highly differentiated products typically have higher profit margins since differentiated products create higher marginal benefits, allowing the company to charge premium prices.

Asset Management Efficiency

Measured by asset turnover i.e. $\frac{\text{Sales}}{\text{Total assets}}$

• & A measurement of capital intensity. The higher the efficiency, the lower the intensity.

For instance, NVIDIA is more capital intensive due to their higher fixed assets (R&D facilities, testing equipment, infrastructure) as a percentage of total revenue.

Linking to Return on Assets:

• ROA = $\frac{\text{Net income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Total assets}}$ = $\frac{\text{Net income}}{\text{Total assets}}$

Financial Leverage

Measured by equity multiplier

$\frac{\text{Total assets}}{\text{Total equity}}=\frac{\text{Liabilities}+\text{Equity}}{\text{Equity}}$

The equity multiplier measures financial leverage - the extent to which a company uses debt financing relative to equity financing.

ROE can be improved by:

1. Improving operating efficiency (increasing profit margin)
2. Enhancing asset management efficiency (increasing asset turnover)
3. Increasing financial leverage (increasing the equity multiplier through debt financing)