Excel Finance Class 19:Profitablility Rations: Return On Equity & Return On Assets & DuPont Analysis

Welcome to Excel and
Finance Video Number 19. Hey, if you want to download
the PDFs or our Excel file, click on the link
below the video and you download the chapter 3
for this finance class files, both PDF and Excel. Hey– oh, wow, we get to talk
about profitability ratios, profitability ratios. What is the return? Well, profit margin
we've already looked at. That we looked at when we did
common-sized income statements. It's simply net income
divided by sales. That means for every $1 of
sales, what is the net income? For every $1 of sales, how many
pennies of that is our profit? Now here's some points. Just simply– if you have
a high profit margin, a couple things
could be happening. One is maybe you're managing
expenses really well, especially in comparison to
some other business, right? Another possibility–
what if like Whole Foods, they have a kind of a premium
product, there's not very many other people that
specialize like they do an all-organic, all-natural
foods, so they can charge a little bit more, all right? So high profit margin
is probably pretty good, low profit margin is
probably not so good.

Oh, but wait a second. There are businesses
that totally have low profit margins. But maybe they have instead
of a high profit margin generating their profits,
maybe they have high volume. Actually, a lot of supermarkets
have very low profit margins but high turnover. Profit margin. Return on assets, sometimes
also said return on investment. But return on assets, I like
that one because it's just, hey, for every $1 of
asset, what's the profit? Also, return on equity,
very important ratio throughout this book
and throughout finance, return on equity is everywhere.

Now this is pretty
important– net income divided by total equity. So think about
this– $1 of equity, if we paid out all of the net
income to the stockholder, right? It would– this ratio would
give you how many pennies they get for every dollar
goes to the stockholder. Now think about this– even– our net income, we saw
this on the income statement.

Net income goes to two places. It's either paid
out as dividends or it's kept in the company. And the account that net
income is kept in is called retained earnings, and retained
earnings are plowed back into the company and
then you buy new assets. So this really
reflects everything the stockholder
is interested in, because dividends, well
that's cash to the equity holder, which is good,
but also, if they're plowing backlots of retained
earnings and buying new assets, presumably the
company is growing and the stock price will grow. So that's why return on equity
is such a common measure and a lot of people look at it. Now we want to talk about
this a little bit more– you can read some of
these notes if you want, but we want to talk about
this, because there's an amazing thing we can
do to return on equity.

It's called the DuPont analysis. Now in chapter 0.0, we've
talked a little bit about math and we talked
about the number 1. The number 1 is very important. And whoever– the people at
DuPont that thought this up, they knew about the number 1. So check this out. What's net income divided
by equity times 1 times 1? Well anything times
1 is still netting the same original
number, which in our case is net income divided by equity. But watch this– we're going
to choose the type of number 1 we want.

Anything by divided
by itself is 1. So sales times sales
divided by sales is the number 1;
times asset divided by asset, that's the number 1. Well guess what? When we set up this way– net
income over equity times sales over sales times
asset over assets, multiplication in the
denominator and the numerator can be done in any order, right? So right now we have E
for equity, S for sales, A for asset. But we could just as easily
put this A under the S right here– so it'd be SA. Or this S under the net
income and the E over here.

Well that's exactly
what we're going to do. We're going to take this
A, put it right here; the E, put it right here; and
the S and put it right here. Now what do we got? That looks like profit margin,
this looks like asset turnover, and this looks like
equity multiplier. Boom– three very
important ratios. This tells you the
operational efficiency, this one tells you how many
dollars of sales or revenue we get for every $1
of asset, and this tells us the equity multiplier
or looking at leverage, remember? This, anytime we
increase our debt, this is a number bigger than 1. So the more debt we have– so let's say we have half
debt and half equity, then this is the number 2, and
you can multiply it by these to increase it.

So by increasing debt– by breaking apart
return on equity and looking at any one
of these components, it can tell us what
it is that actually increased the return on equity. So if one year we saw 1.5
here, and the next year, return on equity went up really a
lot and you see 2.5 here, you could say, ah,
that's how they did it. They got a bunch of more debt. All right, but each
one of these tells us something important–
operation, efficiency of our assets generating sales,
and the amount of leverage. Now let's notice a
couple other things. Well, net income over
sales, notice there's– when we multiply these
together, it actually gives us a return on asset,
and technically the way you do it is, if you
have a number in the– the numerator and
the denominator, you can cross them out, right? And you're left with just
net income over assets, which is return on assets, right? So these two things
are return on assets.

So we can rewrite it
still another way– return on assets times
the equity multiplier. So sometimes you'll see it just
like this, sometimes you'll see broken apart– so
you have three component parts to help explain how
return on equity changed. Other times you see
it just like this. You just want to see the
return on assets and the equity multiplier. Still further, right? If we do this
little calculation, which we did in chapter 0.0, we
actually looked at this, right? Assets are really equity
plus debt divided by equity. Well break it apart– E over E is 1, that gives
us the 1; and D over E is the debt-to-equity ratio.

So a lot of times you'll
see it written this way. Return on equity? Hey, we got our return on assets
times 1 plus debt to equity. Now this seems all
unnecessary, really, but it really– they're
all different ways to write the same thing. And why do we have so
many different ways? Because this is a
very common number, people look at it all the
time, it's very important. So we can break it apart and see
slightly different perspectives with each one of these. Now I'm going to
go over to Excel, there's a little example
here you can look at. Actually, let's go
ahead and look at it. We have '98 numbers and '99. Well return on equity, 200
divided by 1,000 equity, right? 0.20. Oh, but wait a second. The next year, it's 200,
and equity went up, right? So it's 1,400. So make the division
and we get this number. So return– even
though the profits, the net income stay
the same, we issued a bunch more equity and return
on equity went down a lot.

That's called diluting
the equity, right? You buy– issue a lot
more stocks, right? And there's a lot more owners to
have to split up the earnings. All right, but
let's look at this. If we break this apart,
here's our profitability. Net income divided by sales. So 0.033. Here's our asset efficiency,
our sales divided by our assets.

$3 for every $1 of asset. And then our equity
multiplier, it's 2, right? 2,000 assets, 1,000 equity. So boom, boom, boom. Now looked at– when we do
the same numbers from '99, we can see why it went down
more explicitly, right? Here's the profit
margin in 1998. Profit margin actually
went up a little teeny bit. So that's not–
the profit margin isn't what caused the
return on equity to go down. Here, this one– 3– oh. So that one went down, we're not
being as efficient generating revenue from our assets. And finally, we issued a
bunch of equity, right? So our equity
multiplier went down. So it was efficient use of
assets and our use of leverage that caused our return
on equity to go down. Now let's go over to Excel. We're on the sheet that's
called Whole Food Markets International DuPont, and then
here's the answer over here. Let's just go ahead– before we do our
DuPont analysis, let's just do our straight
profit margin return on assets, return on equity.

Equals, and we're
doing it for 2006. So we're going to say net
income divided by sales. 3.6% or 0.036 as a decimal
or proportional rate. Equals net income divided
by our total assets. That's return on assets, OK? So 0.09. This one– oh,
let's do one more. This is the return on equity. So we're going to take
our net income divided by our total equity. OK, return on equity, 0.14. So what all– what
does this mean, right? For every $1 of sales we
brought in, $0.36 of that dollar went to profit. The rest was
consumed by expenses. For every $1 of asset,
we generated 9.9– about $0.10 worth of profit. This one says for
every $1 of equity, there was about $0.145 cents
of net income or profit. Now, let's break apart. I want to do profit margin,
asset turnover, and equity multiplier– three of them,
because that explains three components of
return on equity, and then want to
actually multiply and see that they are exactly
equal if you do it this way or straight our way right there.

So when we get over here, we
better get the same number. This we just did for 2006, but
we're going to do these numbers for '05 and '06. So net income
divided by our sales. And then equals, for 2006,
net income divided by sales. So 2.9% to 3.6%, or as
a decimal, that to that. All right, our asset turnover
equals our net income– this is 2005– divided by our assets. Oops, I did that wrong. Equal sales divided
by our assets. Equals all the sales for 2006
divided by our assets at the– ending number on
the balance sheet. So from '05 to '06,
we went up, right? We were a little bit more
efficient in generating dollars of sales from our
assets and equity. We're going to say
total assets– whoop– divided by our total equity. And then total assets
divided by our equity. So we're a little bit
more leveraged now, it went up a little bit. Now let's multiply these. All right, I'm going to use
the Product function, Product, and I'm going to multiply these. 1, 2, 3. Now we didn't do a
calculation for 2005, but let's just do it real quick.

That divided by total equity. I got my fingers crossed– yep, exactly the same. Now this is our relative
cell references, so we can copy it down
and ding, ding, ding, we get the same number
we calculated over here. So for now, we have
more information. We can look at each one
of these component parts and figure out why return
on equity went up or down. Now the product of these
two equals return on assets. So let's check that,
and in fact, I probably should have just gone
ahead and maybe I'll leave out that so when
you download the template, it will be just like this. Return on assets, if
I drag that over– so now we have the
return on assets was 7%, and then the profit
margin here was 2.9. OK, and– well let's come
down here and we're going to multiply, do the same thing– we could use the
product or we can just go like this times this. So that's profit margin
times asset turnover, and those are the two component
parts to return on assets, and sure enough, we
get the same thing. I'm going to go ahead
and drag it down.

So now it's multiplying
those, and sure enough, we get that exact number there. One final version of this is
do we know the debt to equity? We don't. We have our debt to equity. We didn't calculate
that anywhere, but we'll go ahead and do that. I'm just going to bring
these, because this is return on assets. So I'm going to
click here, equals, and get my return on assets– I don't need to
recalculate that– and then copy it down.

So that one's just
looking there. And now I'm going to
go equals 1 plus debt– and this is for 2005. So total debt divided
by total equity. I cannot copy this one
down, I have to redo this– equals 1 plus, because
the numbers are not below. 1 plus, and I have
to go over to 2006 and say debt divided by equity. All right, now I want to check.

Better if I multiply return
on assets times the equity multiplier. Remember, that's a different way
to write the equity multiplier. This times this. That is just so cool. Look at that, I got the
same number there and there. All right. This video was a little
bit about profit ratios and the DuPont analysis. When we come back, we have a
few more ratios to look at. We'll see you next video..

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