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ROE and Dupont Analysis

ROE and Dupont Analysis

April 12, 2023

"Show me the money!" - Jerry McGuire


If you own a company when do you get paid?


Let's imagine you own stock in a company, and that company sells a product. Does that mean you get paid? 


Not necessarily. The company has generated a cash flow called REVENUE. The company might spend all, or even more, of the proceeds on its expenses. The company might still be losing more money than it generates.


Okay, so if the company doesn't lose more money than it generates, does that mean you get paid?


Not necessarily. The company has generated a cash flow called FREE CASH FLOW. The company might still have 'paper' losses which wipe out any profits. An example of this would be depreciation on assets purchased in the past. The company's bank account might be flush with cash, but it has no profits. At least not on paper, because it is wiping out its current year profits with its prior years' losses. 


The good news is that the company doesn't pay taxes. The bad news is that the company doesn't pay you, either. Bummer, since it's your company! (And there's plenty of cash in the bank accounts.)


Okay, so what if the company generates more profits than losses. Does that finally mean you get paid.


Not necessarily. The company has generated a cash flow called EARNINGS. Now the company finally has to pay taxes to the government, but that doesn't mean it has to pay you. It is perfectly acceptable for the company to reinvest all of its earnings into new projects or property.


At this point you may be asking yourself, "Who gets to decide? If I own the company don't I get to decide?"


Not necessarily. The decision-maker who gets to make that call is the CEO of the company, which probably isn't you. The CEO gets to decide what to do with the money, and it's perfectly possible that the CEO wants to spend the money on new projects, or raises for the staff. The CEO doesn't have to pay you.


What incentive does the CEO have to pay you (the owner) instead of buying a new corporate jet? After all, the corporate jet will be available to fly the CEO and their family to their weekend cottage. Why do something silly like pay out the company's cash to its owners?


At this point we come to what's known as the 'Agency Problem' in corporate finance. The concept is that the owners of a company and the management of a company don't always have to same priorities. They have an inherent conflict of interest. The problem in corporate finance is how to navigate this situation smoothly.


You might be asking, "As the owner of the company, don't I get to hire and fire the CEO? Can't I just fire them?" The short answer is 'yes'. The long answer is 'no' - you're just one of millions of shareholders who collectively make that decision. The other shareholders and the elect members of the Board of Trustees would need to agree with you, and they would make the decision of when to hire or fire a CEO.


For simplicity's sake, let's imagine that you're the only shareholder and that your sister is the CEO of your company, and that company has positive EARNINGS


What you want is for your sister, the CEO, to pay those earnings to you. You want the company to generate a cash flow called DIVIDENDS, whereby the company's cash is finally put into your personal pocket.


But how do you know that's a good idea? I mean, what are you going to do with the money anyway? Spend it? Reinvest it? What if your company is growing faster than every other company in the world? Wouldn't you want your sister to keep doing what she's been doing? Wouldn't you want her to reinvest the company's cash in more profitable endeavors?


I think the answer is 'yes'. 


But if the company is not growing, and your sister wanted to keep experimenting with the company's cash, you would likely object. You'd prefer that the company pay its cash to you so that you can reinvest in other companies which are growing faster.


Look what you'd be doing - taking money from a manager who has stopped growing your money, and giving it to different managers who have better ideas and grow your money faster.


In corporate finance, the question you want to ask your CEO sister is, "What is your ROE?" ROE stands for return on equity, and it essentially means: how fast are you growing the money I leave with you?


The math is simple. ROE = Return / Equity.


If your sister wants to keep the corporate cash and spend it on her ideas, she's going to need to make a great case that she is reinvesting that money well. She's going to need to have a high ROE. Naturally, she's going to ask herself, "How do I increase the company's ROE?"


This leads us to a concept called a 'Dupont Analysis'. Here we take advantage of some high school math to note that


ROE = Return / Equity = Return x (Sales / Sales) x (Assets / Assets) / Equity = (Return / Sales) x (Sales / Assets) x (Assets / Equity) = Profitability x Asset Turnover x Leverage


The first term is called 'Profitability', and we note that Profitability = Return / Sales. One way your sister could bolster her case is by being very smart with her income statement - making sure that her prices are high but her costs are low. If she boosts her Profitability, she'll have a higher ROE, and a stronger case to keep your cash. 


The second term is called 'Asset Turnover', which is defined as Asset Turnover = Sales / Assets. Another way for your sister to increase the company's ROE is to be more efficient with her balance sheet - she shouldn't own any assets that aren't making money. She should sell them, turn them to cash, and invest the cash or give it to you!


Finally, the last term is called 'Leverage' and we see that Leverage = Assets / Equity. This one is tricky, because the quickest and easiest method for you sister to increase her ROE is by taking more risk. It involves almost no thinking at all, and it's easy to do. However, taking risk is like picking up pennies in front of a steamroller. Most of the time it's effortless, but one mistake can be very costly.


If you're an owner of a company you should ask yourself if the manager is getting you a sizeable ROE. If so, the next question you should ask is, "How are they getting a terrific ROE?" Is it through stellar expense management? Or balance sheet efficiency? Or risk? If it's risk, that might be okay. Is it too much risk? Or the Goldilocks kind - just right.


Finally, if the ROE is better than what you could get elsewhere, you should leave your sister alone and thank her for the incredible job she's doing. If not, you should look your sister in the eye and say ...


"Show me the money!"

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.