Reverse Engineering Return On Equity

Financial ratios are used both internally by chief executive officers
(CEOs), chief financial officers (CFOs), accountants and financial
managers, as well as externally by accountants and security analysts.
They can be used to gauge the effectiveness of a management team, or
to evaluate the value of the company's stock for purchase or sale.

Ratios are generally accepted across many disciplines and provide an
efficient way to organize large amounts of information into readable
and analyzable output. While return on equity (ROE) has outstanding
evaluation and predictive qualities, return on net operating assets
(RNOA) complements ROE, filling in the gaps and assisting in the
analysis of management's ability to run a company. In this article
we'll explain how interpreting the numbers provides an in-depth
evaluation of management's success in creating profitability and
provides insight into long-term future growth rates.

*TUTORIAL: Financial Ratios*
*Return on Equity (ROE)*ROE is one of the most commonly used and
recognized ratios to analyze the profitability of a business. To the
common stockholder, it is an indication of how effective management
has been with shareholders' capital after excluding payments to all
other net capital contributors.

To derive and differentiate ROE from return on total equity:
Then to make an accurate measure of the common shareholders measure:
Since ROE is an important indicator of performance, it is necessary to
break the ratio into several components to provide an explanation
of a firm's ROE. The DuPont model, created in 1919 by an executive at
E.I. du Pont de Nemours & Co. , breaks ROE into two ratios:
This reveals that ROE equals net profit margin times the equity
turnover. The basic premise of the model implies that management has
two options to increase its ROE and thus increase value to its
* Increase the company's equity turnover and use equity more
* Become more profitable and subsequently increase the company's net
profit margin (For further reading, see _The Bottom Line on
One of the most common ways to increase the efficiency of assets is to
leverage them. Breaking down ROE even more reveals:
*Flaws in ROE*While the DuPont formula has proved useful for many
years, it is flawed in its inability to separate the decisions
regarding both operating and financing changes. For example, an
analyst noting a decline in return on assets (ROA) might conclude
that the company is experiencing lower operating performance when ROE
increased through the use of leverage.

Return on Net Operating Assets (RNOA)
RNOA, on the other hand, successfully separates financing and
operating decisions and measures their effectiveness. RNOA = Operating
Income (After Tax) / Net Operating Assets (NOA)
By isolating the NOA, no incorrect conclusions can be drawn from the
ratio analysis, thus repairing the missing link form the original
DuPont model. Isolating the components also means that changing debt
levels do not change operating assets (OA), the profit before interest
expense, and the RNOA.
ROE = RNOA + (FLEV X Spread)
= Return From Operating Activities + Return From Non-Operating
Activities (Financing)
*Comparing Companies*The best way to understand RNOA and ROE is to
compare historical periods across many companies: For a 34-year period
counting back from 2008, the median ROE achieved by all publicly
traded U.S. companies was 12.2%. This ROE is driven by RNOA as
illustrated in the following median values:

*The data shows that companies in general are financed rather
conservatively as expressed with FLEV< 1.0 and have greater portions
of equity in their capital structures. On average, companies are
rewarded with a positive spread on money borrowed at 3.3% - but this
is not always the case, as seen in the lowest 25% of companies. The
most important conclusion from the output is that RNOA averages
approximately 84% of ROE (10.3% / 12.2%).

*Bottom Line*ROE is a widely used financial ratio used to evaluate
management's ability to run a company. Unfortunately, comparing the
ratios between two companies or year over year might lead to the wrong
conclusion based solely on those results. The DuPont formula does not
separate the operating and non-operating performance and it allows the
use of leverage to misrepresent the results.

Taking the model one step farther by analyzing RNOA provides a much
clearer picture of performance by focusing on operational functions.
Once ROE is broken down into RNOA, FLEV and Spread, one can make more
accurate predictions of long-term future growth rates using the
formula's output.

*by Michael Schmidt*,CFA
Michael Schmidt earned an MBA from Loyola University of Chicago and is
a Chartered Financial Analyst. Mr. Schmidt contributes to the CFA
Institute as part of the Educational Advisory Board and has been part
of the annual grading team since 2001. He has spent 20 years working
as an analyst, a portfolio manager and an institutional investment
consultant with various firms including: Bank of NY Mellon, Evergreen
Investments, Mercer Consulting, INDATA and Coastal Asset Management.
As an analyst he provided buy side research for both internal use and
published for investors. As a portfolio manager he has managed
investment portfolios for the institutional and the high-net-worth
arena with specialties in value and quantitative equity styles and
multiple fixed income strategies. Mr. Schmidt is a staff member of
FINRA's Dispute Resolution Board as an arbitrator and chairperson. He
has also testified as an expert witness in arbitrations and security
litigation in over 40 cases.
Source: Investopedia.Com