Way back in the 1920s, DuPont Corp. gave us a useful way to measure a company's performance: The DuPont analysis was used to gauge a company's performance through its return on equity. ROE is important for investors because it shows how profitable a company is for its shareholders. DuPont breaks down ROE into three parts:
ROE = net profit margin x asset turnover ratio x equity multiplier ratio
Net profit margin: This component gives us an understanding of how effectively a company can convert its revenues into earnings. Net margins vary across industries; what is high in one industry may not be in another.
Asset turnover ratio: This tells us how efficiently a firm converts its available assets to generate revenue. Companies with low profit margins generally tend to have higher asset turnover ratios.
Equity multiplier ratio: This tells us how much liability a company uses to finance its assets, and what portion of ROE is driven by liability. Thus, a company could assume more debt to increase its ROE.
Significance of DuPont
The DuPont formula gives us a better understanding of a company's efficiency. Investors should know exactly where their money is coming from, and that's where the DuPont ROE analysis comes in.
Let's use the DuPont analysis to derive drug retailer Walgreen's (NYSE: WAG) ROE.
|
Metric |
LTM 2011 |
LTM 2010 |
|---|---|---|
| Net margin | 3.36% | 3.10% |
| Asset turnover | 2.63 | 2.56 |
| Equity multiplier | 1.81 | 1.77 |
| Return on equity | 16.00% | 14.00% |
Source: Capital IQ, a division of Standard & Poor's. NM = not meaningful. LTM = last 12 months.
Walgreen's net margin has increased in the past 12 months. This has come along with an increase in its asset turnover. The equity multiplier has risen as equity has declined and assets have risen.
Let's now see what factors have affected ROE at Walgreen peers.
|
Company |
Net Margin |
Asset Turnover |
Equity Multiplier |
ROE |
|---|---|---|---|---|
| Rite Aid (NYSE: RAD) | (2.16%) | 3.24 | (3.87) | NM |
| CVS Caremark (NYSE: CVS) | 3.33% | 1.59 | 1.71 | 9.2% |
| Kroger (NYSE: KR) | 1.38% | 3.69 | 4.46 | 22.9% |
Source: Capital IQ, a division of Standard & Poor's. NM = not meaningful.
CVS Caremark has a net margin about even with Walgreen's, but has a much lower asset turnover ratio and a comparable equity multiplier, resulting in its lower ROE. Kroger sports the highest ROE in the list, but as can be seen, it is being driven by a high equity multiplier whereas its net margins are lower.
The Foolish bottom line
Even during tough economic conditions, Walgreen has managed to remain profitable, and I expect this trend to continue. Though its recent decision to split up with Express Scripts (Nasdaq: ESRX) will affect its top line, tie-ups with the likes of drugstore.com may help compensate for these losses. Drugstore.com will add more than 3 million customers and 60,000 products to Walgreen's portfolio.
Now that we've broken down Walgreen's ROE using the DuPont analysis, we can see what is driving its ROE. This will give Walgreen investors, or those considering investing in the stock, a better idea of what is powering returns.
