The Chartered Financial Analyst (CFA) exams are considered among the most difficult tests on Wall Street.
There are three levels of exams and all three will be administered on June 1.
One of the more basic concepts that get addressed on the exams is return on equity (ROE).
Simply put, ROE is net income over a company’s book value of equity.
Unfortunately, ROE alone doesn’t tell you much about a company’s operating or capital structure.
That’s why analysts decompose the ROE into multiple components (see below).
CFA exam test-takers are exposed to at least two decompositions of ROE. The more complicated one is the DuPont model.
Goldman Sachs recently included the formula for reference in a recent note sent out to its clients.
As you can see, the DuPont model breaks ROE down to five components. From left to right:
- Operating margin: This is earnings before interest and tax. To put it another way, this is sales less cost of goods and fixed asset expenses. The higher the operating the margin, the more profitable the company.
- Asset turnover: This is the amount of sales generated by a dollar’s worth of assets. It’s a measure of how well a company uses its stuff.
- Borrow cost: This is a measure of financial stress by comparing a company’s interest expenses to its assets. This is not a commonly used measure of leverage. Typically, an analyst will look look at interest expense in relation to EBIT and assets in relation to debt.
- Assets/Equity: This gives a measure of financial leverage. When this ratio is high, liabilities are high, which suggests a high level of leverage.
- Tax: This capture the companies effective tax rate.
As you can see, this is much more information than what you would get from just a income and equity.
Everyone in the CFA program remember and master this concept.
Novice investors who want to take it to the next level should master this too.