Decompose ROE Before You Admire It
Break ROE into profit margin, asset turnover, and leverage to identify the real source of returns.
Two companies both show ROE near 24 percent. Decide which one deserves a quality premium. DuPont ROE = profit margin x asset turnover x equity multiplier Treating high ROE as proof of quality without checking whether leverage or one-time margin effects created it. Margin Company A earns 12 percent net margin; Company B earns 7 percent net margin. Margin shows pricing power and cost structure. A higher margin can be durable, but only if it is not a temporary accounting or cycle effect. Turnover Company A turns assets 1.1x; Company B turns assets 1.4x. Asset turnover shows how much revenue…
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