Investments, tenth edition

 Table 19.6 

 Economic value 

added, 2012 

  

 Ticker 

 EVA 

($ billion) 

 Capital 

($ billion) 

 ROC (%) 

 Cost of 

Capital (%) 

 Microsoft  

MSFT  

4.76  

81.2  

14.2  

8.4 

 ExxonMobil  

XOM  

3.63  

179.06  

9.3  

7.3 

 Intel  

INTC  

3.44  

56.34  

13.9  

7.8 

 GlaxoSmithKline  

GSK  

2.13  

38.10  

11.0  

5.4 

 Google  

GOOG  

1.36  

75.95  

10.5  

8.7 

 Home Depot 

 HD  

1.07  

28.57  

11.2  

7.4 

 Hewlett Packard 

 HPQ 

  2 0.58 

 50.88  

4.9  

6.0 

 AT&T  

T 

  2 1.59 

 164.38  

3.9  

4.9 

   Decomposition of ROE 

 To understand the factors affecting a firm’s ROE, particularly its trend over time and its 

performance relative to competitors, analysts often “decompose” ROE into the product of 

a series of ratios. Each component ratio is in itself meaningful, and the process serves to 

focus the analyst’s attention on the separate factors influencing performance. This kind of 

decomposition of ROE is often called the    DuPont  system.      

 One useful decomposition of ROE is   

ROE

5

Net profit

Equity

5

Net profits

Pretax profits

3

Pretax profits

EBIT

3

EBIT

Sales

3

Sales

Assets

3

Assets

Equity

(1)

3

(2)

3 (3) 3 (4) 3 (5)

   

(19.2)

    19.4 

Ratio Analysis 

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 Security 

Analysis

 Table 19.7  shows all these ratios for Nodett and Somdett Corporations under the three dif-

ferent economic scenarios. Let us first focus on factors 3 and 4. Notice that their product, 

EBIT/Assets, gives us the firm’s ROA.  

 Factor 3 is known as the firm’s operating    profit  margin    or    return  on  sales     (ROS), 

which equals operating profit per dollar of sales. In a normal year, profit margin is .10, or 

10%; in a bad year, it is .0625, or 6.25%; and in a good year, .125, or 12.5%. 

 Factor 4, the ratio of sales to total assets, is known as    total  asset  turnover    (ATO). It 

indicates the efficiency of the firm’s use of assets in the sense that it measures the annual 

sales generated by each dollar of assets. In a normal year, ATO for both firms is 1.0 per 

year, meaning that sales of $1 per year were generated per dollar of assets. In a bad year, 

this ratio declines to .8 per year, and in a good year, it rises to 1.2 per year. 

 Comparing Nodett and Somdett, we see that factors 3 and 4 do not depend on a firm’s 

financial leverage. The firms’ ratios are equal to each other in all three scenarios. Similarly, 

factor 1, the ratio of net income after taxes to pretax profit, is the same for both firms. 

We call this the  tax-burden ratio.  Its value reflects both the government’s tax code and the 

policies pursued by the firm in trying to minimize its tax burden. In our example it does not 

change over the business cycle, remaining a constant .6. 

 Although factors 1, 3, and 4 are not affected by a firm’s capital structure, factors 2 and 

5 are. Factor 2 is the ratio of pretax profits to EBIT. The firm’s pretax profits will be great-

est when there are no interest payments to be made to debtholders. In fact, another way to 

express this ratio is   

Pretax profits

EBIT

5

EBIT

2 Interest expense

EBIT

 

We will call this factor the  interest-burden ratio.  It takes on its highest possible value, 1, 

for Nodett, which has no financial leverage. The higher the degree of financial leverage, 

the lower the interest burden ratio. Nodett’s ratio does not vary over the business cycle. 

It is fixed at 1.0, reflecting the total absence of interest payments. For Somdett, how-

ever, because interest expense is fixed in a dollar amount while EBIT varies, the interest 

burden ratio varies from a low of .36 in a bad year to a high of .787 in a good year.