In the strategic profit formula, sometimes called the DuPont formula because it originated in DuPonts finance department, its easy to see the links in the chain: profitability, productivity, and capital structure, in sequence:
Return on equity = x x
The intermediate terms in this formula tell a great deal about the health of the business. For each intermediate term in the formula, you want to know its value, in what direction its going, and how it compares to others in the industry.
ROE, defined as net earnings divided by owners equity, is a capitalists bottom line. It represents the return on owners equity invested in the business. As a practical matter, although it can be jiggered somewhat through accounting policy and practice, its a good barometer to determine whether the company is on the right track and whether management is doing a good job. Other things to know about ROE:
Over time, ROE trends toward the earnings growth rate of the company. A company with a 5 percent earnings growth rate and a 20 percent ROE today will see ROE gradually diminish toward 5 percent. A company with a 20 percent earnings growth rate and a 10 percent ROE will see ROE move toward 20 percent, as the numerator grows at a faster rate than the denominator.ROE doesnt just happen all by itself. A series of business fundamentals, all linked together and controlled or influenced by management, leads to respectable, sustained, and growing ROE. The links are profitability, productivity, and capital structure. When all three are strong and tight, ROE outcome is destined for success. If a business fundamental is poor or failing, it can weaken the entire chain and hamper ROE indefinitely.
Pay attention to ROTC, return on total capital. ROTC is owners equity plus long – term debt. If a company is growing ROE but not ROTC, chances are the company is borrowing to fund growth – producing assets, thus leveraging the company. So look at ROTC and ROE together. They should march side by side and change in unison. Many information services such as Value Line provide both figures simultaneously.
Unlike intrinsic value, covered in the preceding section, ROE doesnt purport to estimate the value of a company. Although intrinsic value is an absolute measure of company value, ROE and its components tend to be relative to past performance and to the performance of other businesses.
Bottom line: Maintaining a constant ROE percentage requires steady earnings growth. For that reason, a company with increasing ROE, without undue exposure to debt or leverage, is especially attractive.
