In this article, let´s see one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the Return on Equity (ROE), and we are going to analyze it in the case of DSW Inc. (DSW, Financial).
ROE is calculated as net income applicable to common shares divided by the average book value of common equity: ROE = Net Income / Av. Book Value
A higher ROE is viewed as a positive aspect for the company, but the reason behind it should be examine. From the equation above, we can see that if book value is decreasing more rapidly than net income, the ratio will increase, but this is not good for the firm.
DuPont analysis
This approach can be used to analyze the ROE. With some algebra we can break down ROE into a function of different ratios. Firstly, we are going to consider the original approach:
Original Dupont equation: Three-part DuPont
Taking the ROE equation: ROE = net income / shareholder's equity and multiplying ROE by (revenue / revenue), and rearranging terms we get:
ROE = (net income / revenue) * (revenue / shareholder's equity)
We now have ROE broken into two parts, the first is net profit margin, and the second is the equity turnover ratio. Now we can expand this by multiplying these terms by (assets / assets), and rearranging we end up with the three-step DuPont equation.
ROE = (Net Income / Revenue) * (Revenue / Assets) * (Assets / Shareholder's Equity)
This equation for ROE breaks it into three widely used and studied components:
ROE = (Net profit margin)* (Asset Turnover) * (Leverage ratio)
The first term is what we called previously net profit margin, the second term is asset turnover and the third tem is a financial leverage ratio. If we have a low ROE, one of the following must be true:
- The firm has a poor profit margin
- The firm has a poor asset turnover
- The firm has a little leverage
| ROE (%) 3-Step | Jan 04 | Jan 05 | Jan 06 | Jan 07 | Jan 08 | Jan 09 | Jan 10 | Jan 11 | Jan 12 | Jan 13 |
| Net Profit Margin | 3.64 | 3.25 | 5.12 | 3.83 | 1.84 | 3.42 | 5.91 | 8.63 | 6.49 | 6.39 |
| Asset Turnover | 2.43 | 2.25 | 2.1 | 2.03 | 2.03 | 1.88 | 1.81 | 1.68 | 1.79 | 1.67 |
| Leverage | 2,22 | 1,67 | 1,61 | 1,59 | 1,54 | 1,61 | 1,56 | 1,54 | 1,47 | 1,43 |
| ROE | 19.55 | 12.20 | 17.48 | 12.41 | 5.78 | 10.43 | 16.80 | 22.22 | 17.06 | 15.15 |
Final comment
As outlined in the article, a key ratio used to determine management efficiency is the ROE. In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. As we can appreciate, the ROE was higher in the great majority of the years, principally due to its net profit margin. Further, this margin made ROE to recover better levels in the last few years.
It is very important to understand this metric before investing and it is important to look at the trend in ROE over time. So let´s see the evolution on the next chart:
So based on this analysis, I would recommend investors to consider adding this stock to their long-term portfolios.
Hedge fund gurus have also been active in the company. Gurus like David Einhorn (Trades, Portfolio), Chuck Royce (Trades, Portfolio), Jim Simons (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and Murray Stahl (Trades, Portfolio) added the stock in the second quarter of 2014.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
