Why ROE Can Look Great and Still Mislead: The DuPont Breakdown
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6 min read
Two companies both report a return on equity of 20%. Same number. Same headline.
Would you treat them the same? You should not. One may earn that 20% by running a good business. The other may earn it by borrowing a lot of money.
A tool called DuPont analysis tells them apart. This post explains it in plain words with two invented companies. It does not say any stock is a good or bad buy.
ROE stands for return on equity. It asks one question: how much profit does a company make for each rupiah that owners have put in?
Equity is what is left of the company's assets after it pays all its debts. It is the owners' share.
If a company earns Rp20 miliar on Rp100 miliar of equity, ROE is 20%. We looked at ROE for banks in our post on PBV and ROE for IDX bank stocks. Here we open the number up.
DuPont analysis splits ROE into three smaller ratios. Multiply them and you get ROE back. Guides on the method agree on the three parts (Learn Signal, Accurate).
Here is each piece:
Some sources use average balances over the year. Others use year-end balances. Check which one a source uses before you compare numbers.
We will use two invented companies. They are not real issuers. All numbers are NetWort arithmetic, in rupiah billions.
| Line | PT Contoh Mantap | PT Contoh Ngutang |
|---|---|---|
| Sales | 1,000 | 1,000 |
| Net profit | 100 | 40 |
| Total assets | 1,000 | 1,000 |
| Equity | 500 | 200 |
| Debt (assets minus equity) | 500 | 800 |
| ROE | 20% | 20% |
Now break each ROE into its three pieces.
| Piece | PT Contoh Mantap | PT Contoh Ngutang |
|---|---|---|
| Net profit margin | 10% | 4% |
| Asset turnover | 1.0x | 1.0x |
| Equity multiplier | 2.0x | 5.0x |
| ROE (all three multiplied) | 10% × 1.0 × 2.0 = 20% | 4% × 1.0 × 5.0 = 20% |
The ROE is the same. The route is not.
PT Contoh Mantap keeps Rp10 of every Rp100 in sales. It uses a moderate amount of debt.
PT Contoh Ngutang keeps only Rp4. It gets to 20% because its owners put in just Rp200 miliar against Rp1,000 miliar of assets. The rest is debt.
Leverage means using borrowed money. Debt makes a good year look better, because profit is shared among a smaller pool of owners' money.
It does the same in a bad year, in the other direction. Say costs rise and each company's profit margin drops by 2 points. Sales and assets stay the same.
| After a 2-point drop in margin | PT Contoh Mantap | PT Contoh Ngutang |
|---|---|---|
| Net profit margin | 8% | 2% |
| Net profit | 80 | 20 |
| ROE | 16% | 10% |
| ROE change | −4 points | −10 points |
The same shock took 4 points off one company and 10 points off the other. Half of PT Contoh Ngutang's profit vanished. The thin margin left little room.
This is a simplified picture. We left out interest costs, which grow when debt grows. Our post on the interest coverage ratio shows how to check if a company can pay that bill from its own profit.
The three pieces give three typical paths. Real companies often mix them.
None is wrong by itself. The question is whether the path fits the business and can last. A steady business with predictable income can carry more debt than a company whose profit swings with commodity prices.
DuPont analysis is a way to read ROE, not a verdict. Keep these points in mind:
Debt also depends on interest rates. Our macro page tracks the BI rate and other rates that decide how costly that debt is.
Open the Explore screener and shortlist two IDX companies from the same sector. Explore does not show ROE, so open each one's latest report and run the three-piece breakdown. Then ask yourself which one gets its ROE from the business and which from debt.