|Course 305: Quantifying Competitive Advantages|
We've mentioned that margin and turnover mean little when used by themselves and should be compared with the margins and turnover ratios of other, very similar companies. There is one equation, the so-called DuPont equation, that helps tie all the concepts together. The DuPont equation simply breaks down the components of ROA and ROE. You may recall the following formula for ROA (For simplicity, we will ignore aftertax interest expenses.)
Return on Assets = Net Profits / (Average Assets)
But we can also express ROA this way:
Return on Assets = (Asset Turnover) x (Net Profit Margin)
If we break this equation down further by defining turnover and margin, we can see why this works--sales in the definitions of turnover and margin cancel each other out.
ROA = ((Sales) / (Average Assets)) x ((Net Profits) / (Sales))
(Net Profits) / (Average Assets)
We aren't just doing random algebra for fun here. Rather, this highlights the two different ways a company can create high returns for itself. Companies can either use their assets more efficiently to generate sales, or they can have higher profit margins, or both.
Next: Margin vs. Turnover >>
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