Question of the Week

Demonstrate, using equations from the Dupont or similar ratio model, how and why a high-margin business such as an Auto Dealership (AD) can have the same Return on Equity as a low-margin donut shop business (DS).

A. The key to this question is the relationship between margins and turns in the ROE portion of ratio models and formulas.

ROE = NI/E = Sales/E * NI/Sales

Or in other words,

ROE = Margins * Equity Turns

In the case of this example, assume AD and DS both have a ROE of 12%. From the model:

AD = .24 * .5 = .12 ("Half a turn")

DS = .01 * 12 = .12 ("12 turns")

In other words when generating ROE:
higher margins times lower turns = lower margins times higher turns

(Don't confuse, but relate, turns with returns).

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