Three measures are better than one. Return on equity, ROE, is arguably the best single measure of how shareholders profit from a company. ROE is a direct measure of a firm’s profitability used to asses an organization's financial performance from the perspective of its owners, and higher ROE values depict faster equity growth. However, investment analysis is hard to boil down to just one number. A more accurate view of the health of a company is created by decomposing ROE into three other financial ratios: return on sales, return on assets and the financial leverage.

DuPont Analysis

Return on equity can be split into three factors in a process called DuPont Analysis. The three contributing factors that multiply to create return on equity are return on sales, financial leverage and asset turnover. This analysis provides insight into how a company grows the value of equity based on its more basic components.

Return on Sales

Return on sales is one of the factors of the DuPont analysis. It is net income divided by sales, and it is also commonly referred to as the profit margin. A company’s return on sales is how much of each dollar of revenue the company keeps as profit. If all else is equal, higher return on sales will generate higher ROE values.

Return on Assets

Return on assets, ROA, is related to return on equity through financial leverage ratio. Return on assets is net income divided by the total value of a company’s assets, and return on equity is net income divided by the total value of the company’s equity. They differ in their denominators, the ‘A’ in ROA and the ‘E’ in ROE. ROA can be calculated as the product of ROE multiplied by financial leverage, which is itself assets divided by equity. All else being equal, return on equity increases as return on assets increases.

ROE Drivers

The breakdown of ROE into various components is important to interpret the effect of various drivers of shareholder returns, not ROE alone. Both return on sales and return on assets are directly proportional to the ROE. Management should take steps to increase each of these contributors to increase return on equity.