Q:
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).

Have a Financial Question?

RELATED FAQS

  1. What level of return on equity is common for a company in the banking sector?

    Discover what the average return on equity (ROE) ratio is for companies in the banking industry, and understand the significance ...
  2. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ...
  3. What is the average return on equity for a company in the forest products sector?

    Investing in the forestry sector can provide a hedge against other asset classes, but investors should be aware of the sector's ...
  4. How do you determine a tangible asset's useful life?

    Learn what the average return on equity for a company in the chemicals sector is and what factors influence changes in the ...
  5. What are the main differences between return on equity (ROE) and return on assets ...

    Return on equity (ROE) and return on assets (ROA) are two of the most important measures for evaluating how effectively a ...
  6. What is the average return on equity for a company in the utilities sector?

    Learn specifics about the utilities sector, how return on equity is determined and what the average ROE is for the utilities ...
RELATED TERMS
  1. Return On Equity - ROE

    The amount of net income returned as a percentage of shareholders ...
  2. DuPont Analysis

    A method of performance measurement that was started by the DuPont ...
  3. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  4. Profitability Ratios

    A class of financial metrics that are used to assess a business's ...
  5. Margin

    1. Borrowed money that is used to purchase securities. This practice ...
  6. Model Risk

    A type of risk that occurs when a financial model used to measure ...
Trading Center