How an explosive salesman's old equation helps explain why stock market valuations are high 🧮
A crash course on return on capital and the DuPont decomposition of ROE 🧐
We’ve discussed how higher profit margins justify higher stock market valuations.
Today, I’ll attempt to explain that connection with a crash course on return on capital (ROC).
An explosive salesman’s equation 💥
ROC is a foundational concept in investing. Books are written on it. And the more you dig into it, the more complicated it gets.
“At the end of the day, return on capital determines the value of a business more than any other single factor,” Nicholas Colas, co-founder of DataTrek Research, wrote on Tuesday.
Simply put, it measures a company’s profitability relative to the money you invest.
For stock market investors, a more precise and relevant metric is return on equity (ROE). In its simplest form, ROE is calculated by dividing a company’s net income by its book value of equity.
But as is often the case, there’s limited information we can obtain from a metric involving two variables.
Enter the DuPont decomposition of ROE. Developed a century ago by Donaldson Brown — a former explosives salesman — for the DuPont chemical company, this analytical framework uses identities to expand ROE into a more complex equation with many more variables.
