I’m trying to figure out what levers a company has to raise ROE. It seems even though there are 3 factors (profit, turnover, leverage) in the DuPont, whatever one does to sales or assets just cancel each out in the formula, right? So, that just brings us back to net income over equity. I understand how shareholders benefit from greater net income (which pours into equity), but how do they benefit from less equity?
The shareholders that still have equity get a higher return on it. If you are going to lever up to improve ROE, that would imply either massive expansion of capital and turnover (because new debt capital would have to be put to use) or (more likely) buying shares back from existing stockholders. There is less equity on the balance sheet under scenario two, but there are also fewer shareholders (because some got their shares bought back). I think the theory is that existing stockholders who sold their shares in the buyback would either have doubts that the increased ROE could be obtained without undue risk (and therefore the stock would be overvalued), or they would just want to take their profits now. So, assuming that you have increased ROE by increasing financial leverage, and you didn’t part with any shares, your return on capital has gone up. Of course, your risk has gone up too, because the beta to the market will increase with leverage, so if you feel that the extra ROE is a bargain in relationship to the extra risk, you keep your stock and come out with more returns. If not, you sell your stock, and feel good that you aren’t exposed to that risk.
Thanks very much. From your comments I understand the bigger-pieces-of-same-pie (where the “pie” is company profit) idea as the reason why less equity can be more valuable (to the remaining holders). But I’m going to have to chew on your comments a bit more to fully understand how changes in sales and assets do or don’t affect ROE.
I didn’t really get your point about sales and assets just cancelling each other out. I assume you’re referring to the Dupont model, in which cancelling out terms just tells you why the terms in the model multiply together to give you ROE (or ROA if you aren’t looking at the financial leverage part). Dupont is still useful because it helps identify the drivers of ROE, and those drivers are real, even if mathematically they cancel out. Higher sales -> higher asset turnover (unless you suddenly have more assets too), so even if profit margins don’t change and financial leverage doesn’t change, your ROE will be higher. In concrete terms, it means that even if you are still making only 5 cents profit per sale, you’re now making more sales, so profits are up. On the asset side, if total assets are increasing (more inventory, more factories, etc), then asset turnover goes down, reducing net income. This assumes that revenues are constant, or at least not growing faster in percentage terms than the total asset growth. In concrete terms, what’s happening is that your net income is being used to purchase more assets, so it’s not available for distribution to shareholders as earnings or dividends. In early stage businesses, this is usually considered a good thing, since most of the value is in the company’s growth potential
Don’t let the DuPont model drive your understanding of how companies work. For example, assuming any operating leverage at all (i.e., some portion of COGS is fixed), then increased sales will increase both profitability and asset turnover. E.g. a 10% sales increase could improve NI by 15%, and might require only 8% increase in assets.