The Dupont ROE Formula and How Companies Make Money For Investors

The Dupont ROE Formula and How Companies Make Money For Investors

If you want to make money, go where the money is!1

In the stock market it is possible to make money by buying a stock in a company that is not making any money and that will never make any money. If you buy the stock at one price and are able to sell it at a higher price, you can make money no matter that the company is losing money. But that’s a dangerous and risky strategy.

A far more reliable way to make money in the stock market is to buy (reasonably priced) shares in a profitable company and to benefit as the company continues to make profits over the years.

Investors should understand how companies make money.

This article will review the basics of a balance sheet and income statement and will break out components that illustrate how companies can make attractive returns for their owners.

A Profitable Company

The essence of a profitable company is an enterprise that can sell a product or service at a price that is higher than its costs.

A profitable company usually requires the owner(s) to have contributed some initial money. Usually the company has an investment in both temporary assets (cash, inventory and accounts receivable) and (especially for larger companies) more permanent assets (land, buildings, machinery, office equipment, vehicles). In addition to these assets, a company almost always incurs expenses for things such as purchased goods, purchased raw material, hired employees, utilities, shipping costs, contracted services and many other things. A profitable company also incurs income taxes.

An Attractive Return

What investors really want is not just a profit, but a reasonable profit in relation to their investment. A $100,000 dollar profit is beyond exceptional if it is earned, in one year, on an investment of $100,000. And it’s quite acceptable if earned on an investment of $1,000,000. But it would very mediocre and unacceptable if it were earned yearly on a business investment of $10 million.

The owner of a private business (where the shares don’t trade) wishes to maximise his or her return over time. This is measured as net income (profit) divided by the owner’s investment. Since the owners investment can also be referred to as owner’s equity and since return means profit, the owner’s return is often referred to as ROE or return on equity.

Stock investors would be wise to focus on investing in companies that are earning a high ROE. Over time, these companies can provide strong returns for all their long-term owners and their investors need not rely on astutely selling their shares to other investors at opportune times.

The Income Statement

The following is a simplified Income Statement that has been broken down into key categories, and shows subtotals that are essential to understanding how different businesses make profits. This income statement represents the results of operations for a given period of time such as one month, one year or one quarter of a year.

Line Item Abbreviation Explanation
Revenues The “top
line. All profits ultimately derive from revenues which are also know as sales.
Operating Expenses other than depreciation Wages, rent, utilities, purchased materials, inventories used in production, shipping costs, and many other cash expenses.
Subtotal EBITDA Earnings Before Interest, Taxes, Depreciation and Amortization.
Depreciation and Amortization This represents charging a portion of the costs long-lived assets to this particular period.
Subtotal EBIT Earnings Before Interest and (income) Taxes.
Interest The interest paid on borrowed money.
Subtotal EBT Earnings Before (income) Tax.
Income Taxes
Net Income The “bottom line” also know as profit or earnings.

For every business we can say that the top line revenues are 100% of the money coming in the door from customers. The amount of this 100% taken up by all the other line items varies enormously. And the percentage of the revenues that ultimately falls to the bottom line as profits also varies enormously.

When evaluating the success of a business, it is not enough to know just the percentage of revenues that that fall to the bottom line. We would also want to explore whether the bottom line profits were influenced by an unusual income tax rate or unusually high or low interest costs. We also want to understand the impact of depreciation because of its special nature.

The profitability of a company in terms of the percentage of sales that fall to the bottom line is important. But of much greater importance to an owner is the profit as a percentage of the owner’s equity investment, the ROE.

In order to explore the ROE we must look at the balance sheet of the company

The Balance Sheet

The following is a balance sheet, simplified to the maximum extent possible

Assets Liabilities and Equity
Assets $ Liabilities $
Owner’s Equity $
Total $ Total $

The balance sheet is called a balance sheet because the liabilities and owners equity must always precisely equal or balance the total assets. This is the case because the owners equity is defined as what is left over after the liabilities are subtracted from the total asset value.

It can be observed that the investment in assets is funded by or supported partly by owners equity and partly by liabilities (which, of course include debt). In many cases the use of liabilities and debt instead of owners equity can leverage or magnify the return on owners equity.

As noted above, the return on equity or ROE is defined as the profit divided by the owners equity. However, the owners equity changes from the start to the end of the month or year over which the profit is measured. Therefore we usually divide the profit by the average of the beginning and ending owners equity.

ROE is usually expressed on an annual basis. Therefore the ROE in a one month period would be multiplied by 12 to annualize it.

Analsysing and Understanding ROE

Over time companies wish to maximize the return on owners’ equity. From the above two financial statements we can observe that there are various means to do this.

From the balance sheet, we can observe that all else being equal (though it seldom is) a company can increase its ROE by using more debt and less equity investment.

From the Income statement and working from the bottom up, we can see that profits increase with lower income tax rates, with lower interest charges, with lower depreciation, with lower operating expenses and with higher revenues.

However many of these factors interact in an offsetting manner. Higher debt leverage leads to higher interest expenses. Lower depreciation might require less assets but this could reduce revenues. Lower staff costs could certainly reduce revenues.

In the 1920’s the Dupont company developed a formula that is helpful in understanding how the different ratios from the income statement and balance sheet work together to produce the end goal, a return on investment.

The Three Component Dupont Formula

This formula observes that ROE can be broken out into three key contributing factors ROE or Earnings/Equity = Earnings/Sales x Sales/Assets x Assets/ Equity
This formula relates the earnings or profits over sales from the income statement to the balance sheet.

The three component Dupont formula could be described as ROE equals profit / sales times operating leverage (sales /assets) times financial leverage.

For example, one company might earn 10% earnings on sales. But if it sales are only 25% as large as its investment in assets and if the owners equity is 50% as large as the assets (assets twice as large as equity) then the ROE would be:

10% times 1/4 times 2/1 = 5%.

Meanwhile another company might earn only 2% bottom line earnings on sales but might have sales that are five times as large as its investment in assets and might have owners equity that is only 25% as large as its assets (its assets are four times larger than its equity, due to the use of debt). Its ROE would be:

2% times 5/1 times 4/1 = 40%

In these perhaps extreme examples a company earning 2% on sales provides a return on equity that is far higher than a company that earns 10% on sales. The Dupont formula helps us to understand why. And it can help companies make adjustments to improve the ROE if possible.

The Five Component Dupont Formula

This formula breaks the ROE down into five components by starting somewhat higher “up” the income statement at the Earnings Before Interest and (income) Tax level, EBIT.

ROE = EBIT/Sales x EBT/EBIT x Earnings/EBT x Sales/Assets x Assets/ Equity

This formula breaks out the Earnings/Sales component into three components by starting with EBIT/Sales and then applying a ratio that shows how much of the EBIT (Earnings Before Interest and Tax) is lost to interest expenses, leaving EBT and then shows how much of the EBT is lost to income taxes, leaving E or earnings.

Real Life Examples

Below I have summarized the actual results of applying the Dupont formula to a number of different companies. For these companies I have tracked all the ratios needed for the three step formula and I track the tax ratio. So I will show the results of the three step formula plus I will show the tax rate. In this way we can gain insight into how certain companies have achieved their ROEs. It’s important to note that this analysis would be very misleading if the variables for each company were not reasonably stable. I have used adjusted earnings which will tend to stabilize the variables to a good degree. The data here relies on information from late 2013 in most cases but is from earlier in 2013 in some cases.

The information here is not meant to suggest that any of these companies are either good or bad investments at this time. That would depend on (among other things) the stock price which we have not analyzed here at all.

The Dupont formula calculates return on the ending equity rather than the more familiar return on the average equity during the period.

Company ROE   Profit / Sales   Sales / Assets   Assets / Equity   Tax Rate
Canadian National
Railway Company (CNR, Toronto CNI, New York)
22% = 25% x 0.37 x 2.40 27%
Canadian Western Bank (CWB, Toronto) 13% = 31% x 0.03 x 13.26 25%
Stantec Inc. (STN, Toronto) 18% = 7% x 1.32 x 1.93 27%
Canadian Tire (CTC.a, TO) 11% = 5% x 0.88 x 2.63 26%
8% = 20% x 0.18 x 2.22 22%
Alimentation Couche-Tard Inc., ATD.B 20% = 2% x 3.54 x 2.94 12%
FIRSTSERVICE CORPORATION (FSV, Toronto) (FSRV, NASDAQ) 21% = 2% x 1.67 x 5.89 123%
Wal-Mart (WMT, New York) 23% = 4% x 2.26 x 2.86 32%
FedEx (FDX,NY) 11% = 4% x 1.32 x 1.91 36%
Microsoft (MSFT, NASDAQ) 33% = 32% x 0.59 x 1.77 24%
Berkshire Hathaway Inc. (BRKB, New
7% = 8% x 0.39 x 2.20 32%
Boston Pizza Royalties Income Fund (BPF.un,
10% = 56% x 0.12 x 1.60 74%
Costco (COST, N) 18% = 2% x 3.29 x 2.88 33%
Wells Fargo (WFC, United States) 14% = 24% x 0.06 x 10.03 34%
Toll Brothers Inc. (TOL, New York) 5% = 7% x 0.36 x 2.05 36%
RioCan Real Estate Investment Trust (REI.UN,
7% = 40% x 0.09 x 2.06 0%
Bank of America Corporation (BAC, New York) 3% = 8% x 0.04 x 9.71 -68%
Dollarama Inc. (DOL, Toronto) 27% = 12% x 1.30 x 1.72 28%
VISA (V) 18% = 41% x 0.33 x 1.31 3%
Constellation Software Inc. (CSU,
73% = 16% x 1.15 x 4.03 16%
Liquor Stores N.A. Ltd. (LIQ, Toronto) 7% = 3% x 1.23 x 1.68 26%
eBay (eBay, NASDAQ) 13% = 19% x 0.39 x 1.76 15%

The first company in the table, Canadian National Railway had an ROE of 22%. The return on sales was high at 22%. But this company is highly asset intensive such that its sales were only 37% as large as its asset investment. It also uses considerable financial leverage such that the assets are 2.4 times higher than its owners equity. Its tax rate is neither unusually high not unusually low at 27%.

The sixth company in the table, Alimentation Couche-Tard arrives at a similar ROE of 20% but gets there in a much different fashion that Canadian National. This company operates thousands of convenience stores and most of its revenues come from gasoline sales. Its profit on sales is low at just 2%. But it has a high operating leverage as its sales are 3.54 times larger than its assets. Its financial leverage is a little higher than that of CNR with assets being 2.94 times larger than the owners equity. Although its profit on sales is low at 2% its low income tax rate of 12% helped it get to even 2%.

Bank of America, near the bottom ot the table, has only a 3% ROE. This is explained by a low profit on sales of 8% (as opposed to the 24% of Wells Fargo bank a few rows above it). Bank of America is like all banks in that its sales or revenues are low in relation to assets, in this case 0.04 times as large as the assets. Bank of America exhibits the high financial leverage that is typical of banks as its assets are 9.71 times larger than its owners equity. It is also benefiting from a negative income tax rate at this time. This bank is still emerging from the financial crisis and its ROE remains unacceptably low.

In the above table the three components of ROE vary widely across different companies. Some (the banks) use extreme financial leverage. Visa has almost no financial leverage. Some are asset intensive (the banks, RioCan and Canadian National for example) and therefore have low operating leverage. Economic theory would suggest that the ROEs would converge to a closer range. In practice the ROE range is still pretty wide. Some companies make a lot more return on equitiy than others even though all of these companies face competition which in theory prevents abnormal ROEs from being earned.


This article has demonstrated how companies deliver the goal of return on equity. The broken-out income statement and the balance sheet and the Dupont analysis can help investors understand the drivers of ROE. If a company has a high ROE, this type of analysis may help to gain insight into whether the high ROE is sustainable. Most investors will not want to undertake this level of analysis. But they might want to follow analysts that do this type of analysis.


Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriendInc.
December 26, 2013

1. The quote, “If you want to make money, go where the money is”, is attributed to Joseph P. Kennedy, who was President JFK’s father.