The 3-step DuPont Analysis disaggregates return on equity (ROE) into 3 components:
ROE = profit margin * asset turnover * equity multiplier
Profit margin and asset turnover both pertain to the company’s operations, whereas the equity multiplier is a measure of leverage that pertains to the company’s financing decisions.
Increasing the company’s leverage can increase ROE if the company is doing well, as the company can borrow money and earn a higher return than the cost of borrowing. In bad times, however, increased leverage can be a bad thing, as the company needs to continue making interest payments even if it is losing money. Thus, leverage makes good situations better and bad situations worse.
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