YOUR MONEY: Decoding return on equity with Dupont Multiplier

Therefore, its ROE is 20%, i.e, (50/250) *100. If the firm’s average ROE in the last five years is 16% and its ROE is in the increasing trend over the past five years, it indicates the firm is performing better, and it may continue to do so in the future.

By N Sivasankaran

Return on Equity (ROE) is a key variable to be looked at while assessing the financial performance of a company. ROE is a measure of the overall financial performance of a firm.

ROE
ROE of a firm is computed by dividing its profit after tax (net income) by the amount of shareholders’ funds (owners’ equity). Let us take a hypothetical firm Abhinandan Ltd (AL). Its PAT for Q3 of FY 2021 is Rs 50 crore and its shareholders funds on December 31, 2020 is Rs 250 crore.

Therefore, its ROE is 20%, i.e, (50/250) *100. If the firm’s average ROE in the last five years is 16% and its ROE is in the increasing trend over the past five years, it indicates the firm is performing better, and it may continue to do so in the future.

Decomposing ROE using Dupont Multiplier
A rational investor needs to decompose ROE of a firm into five components; namely, operating profit margin, interest burden, tax burden, asset turn and equity multiplier in order to get more insights on the financial performance of a firm. This is known as Dupont Analysis. According to Dupont multiplier, ROE is the output of the product of these five variables.

Operating Profit Margin: It is computed by dividing operating income by the operating revenue. This component is the most significant among the five variables. Therefore, investors should look at the movement in the EBIT margin. A firm with a double-digit EBITM with a rising trend is to be shortlisted for investment.

Interest Burden: It is computed by dividing earnings before taxes (EBT) by the EBIT. For instance, interest burden of AL for current year is 0.75 while it is 0.70 in the previous year. This indicates the firm has reduced its interest expenses in the current year compared to the previous year.

Tax Burden: It is computed by dividing the profit after tax (PAT) by EBT. For example, the tax burden of the firm is 0.70 in the current year while it is 0.65 in the previous year. This reflects that the firm has reduced its tax expenses this year.

Asset Turn: It is calculated by dividing operating revenue of the firm by its total assets. Higher the asset turnover of a firm, better is its asset utilisation efficiency. For example, AT of AL is two times in current year while it is 1.75 in the previous year. We can infer the firm is utilising its assets better in the current year.

Equity Multiplier: It is obtained by dividing the total assets by the owners’ equity. This reflects the impact of financial leverage on the performance of a firm. Higher the equity multiplier, better the financial performance of a firm provided the firm is profitable.

Investors should analyse the financials of a firm before investing their funds. Analysis of the trend and magnitude of ROE and its components is certainly an effective investment filter.

The writer is associate professor of finance, XLRI School of Management, Jamshedpur