Measuring management effectiveness by decomposing returns – I am a big fan of the Du Pont Identity Method or Decomposition Method and often use it to evaluate investments.  Essentially the Du Pont method breaks down Return on Equity into three parts.  1) Net Margin 2) Asset Turnover, and 3) equity multiplier.  The formula looks like this.

(NI/Sales) x (Sales/Assets) x (Assets/ Equity) = ROE

or,

(Net Income) x (Asset Turnover) x (Equity Multiplier) = ROE

If you cancel out sales and assets in the formula, you get back to the simple calculation, which is

NI/Equity = ROE

The way I think about this formula is that management has three levers that it can pull to deliver returns. 

Lever 1: Net Income - Net Income is the common metric that management teams focus on it.  Self explanatory.

Lever 2:  Asset Turnover - This is an important metric and more management teams should focus on it.  Essentially it gives us how much sales a company can produce with a given amount of assets.  Even though a company may have a low net margin, if they can turn their assets several times a year/month, then they can drive good returns.  Think of a car dealer....A dealer sells cars on thin margin, let's say it's 5%.  After he pays for variable, fixed and borrowing costs, a dealer clears 1%.  However, if the average car sits on his lot for less than 30 days, he can make 1% 12 times per year, which can be an attractive return. 

Lever 3: Equity Multiplier - This is a measure of how much leverage management is using to drive returns. Getting terms from suppliers (accounts payable) is a good thing.  Putting on too much bank debt can add more risk.  

A few names profiled in the Digest that may offer high ROE are Dell (Nasdaq: DELL), Western Union (NYSE: WU), GameStop (NYSE: GME), and ABB Ltd. (NYSE: ABB). 

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