The breakdown of return on equity into several components is now referred to as DuPont system.
The return on equity is a useful ratio as the growth rate expected for the future periods is estimated by the relation
Expected growth rate = Expected Return on Equity * Expected Retention ratio
To develop expectation return on equity is broken down into components and expectations are formed at component level.
Three-Component Breakdown System
Return on equity = Net income/Common equity
= Net profit margin * Total asset turnover * Financial leverage
Net profit margin = Net income/Net sales
Total asset turnover = Net sales/Total assets
Financial leverage = Total assets/Common equity
Five-Component Breakdown System
Step 1.
Find
EBIT/Total assets = [EBIT/Net sales]*[Net sales/Total assets]
Step 2
Find
Net profit before tax (NBT)/Total assets = [EBIT/Total assets] – [Interest expense/Total assets]
Step 3
Find
Net profit before tax (NBT)/Common equity = [Net profit before tax (NBT)/Total assets]*[Total assets/Common equity]
Step 4
Find
Return on equity = Net income/Common equity
= [Net profit before tax (NBT)/Common equity]*[100% - Income taxes/Net before taxes]
References
Reilly, Frank F., and Keith C. Brown (2006), Investment Analysis and Portfolio Management, 8th Edition, Thomson South Western, (Main text for the series of revision articles on Security Analysis)
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