High ROE vs Low ROE! What is the concept of ROE ? Normal and Extended Du-Pont analysis

Extended Du-Pont Analysis (The concept of ROE)

 

Two companies having following ROE which will you buy? Other things are constant.

 Definitely an investor will prefer company A as other things are constant. But this will be an irrational behaviour firstly we will go to the root of ROE from where the value has been derived . 

 

Normal DU-Pont Analysis

 

Extended Du-Pont Analysis

 

Now Let us understand each parameter one by one.

a. Tax Effect : It shows how much the tax a company is paying. If these figures are heavily mismatching then there can be a huge possibility that they are making manipulation in taxes to show profits more. Should not be fluctuated more.

 

b. Financial Leverage Effect. It shows what the effect of leverage is having upon the profitability of the company.Increasing is better as company is paying less debt

In the figure above if we see Company B already has a high leverage effect i.e 0.40 (1-0.60) and 0.55 (1-0.45) is the year 2019 and 2020 respectively as compared to Company A which has low leverage effect i.e 0.24 and 0.20 respectively. Which is pretty good for profitability.

 

c. Operating Profit Margin Effect: It shows what the profits a company is earning  without any kind of leverage.Increasing is better as company's operations are good without leverage.

In the figure above we can see both the companies are having almost the same proportion of profits if they do not use leverage.

 

d. Asset Turnover Effect: It shows how much the sales a company is generating with the help of total assets. Increasing is better. As company is efficiently using the assets to generate the sale.

  In the figure above if we see Company B generating the same asset turnover ratio i.e 0.96 and 0.95 for the year 2019 and 2020 respectively as compared to Company A which is generating 0.96 for the year 2019 and 1.00 for the year 2020. Which is showing that company A is efficiently using its assets.

 

e. Solvency Effect : This is most important and should not be looked at as a standalone basis. But should be combined with all the above 4 parameters.

Let us understand how?

The ratio itself shows how debt can impact the solvency of a company. Debt works as an amplifier for the returns of the company.

 

When Higher is better ?  It is a boom for those companies whose above mentioned all 4 parameters are good. Because it is a cheap source of finance.

 When Lower is better?  It is a curse for those companies whose above mentioned all 4 parameters are not performing well. Because it can be a cause of liquidation of the company.

 

Hence many times we see in the stock market that a company has increased the debt and share falls sharply and another company who has increased the debt its share rises sharply that is the concept behind debt.

 

Investor Choices.