Analysts tend to focus in on how it is that a company’s returns directly relate to their personal returns by measuring the company’s ability to create a Return on Equity capital. This ROE metric has become famous as a basic benchmark for measuring the company’s ability to create returns for an individual investor. From there, analysts have managed to determine a three and five factor model that will describe the fundamental aspects of a company’s aspects that will create RoE. This function is called the Dupont formula, and will help us to evaluate how it is that a company is generating returns for an investor, and whether we want to be a part of those returns.
The basic Dupont Model for measuring return on equity consists of three main aspects. By multiplying a company’s Profit Margin, Asset Turnover, and Leverage Ratio, we can not only calculate the company’s actual return on equity, but we can also evaluate where it is that this return is coming from with respect to the formula inputs. By using the assuming that a firm’s ability to pay investors is a factor of either its profitability, ability to churn assets, or leverage its assets, we can evaluate the quality of returns that are being generated by the operation.
By far, the highest quality of returns to go into the ROE metric come from the sheer profitability of the organization. It doesn’t matter what industry this metric relates to, a higher margin of profitability will always represent a strong return for investors, as a result of competitive advantage and operational efficiency. From there, we would want to see a high asset turnover (sales/assets), to demonstrate the company has been seeing a good return on its investments into fixed assets and production facilities. While a company might have a lower profit margin, a strong asset turnover metric will demonstrate that the company has made good use of the money it is sinking into its capabilities.
Lastly, the aspect of the formula that is most controversial is the leverage ratio. While leverage directly correlates with the returns of the company by magnifying them, it also greatly increases the risk of the business because it adds a fixed operating obligation to be made. We therefore want to take leverage ratio into consideration against the asset turnover ratio, because of the way in which debt financing is traditionally tied to fixed assets.
If a company has high leverage, but a high asset turnover, it shows that the company has likely made a very strong investment using debt financing. However, if a company has a high leverage ratio and low asset turnover, regardless of overall profitability, we’ll want to dig deeper into the company’s history to determine what’s really going on in, so that we don’t’ wind up buying into a company that is significantly over leveraged.
