Profit Margin
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Profit margin = (Net income) / (Revenue)
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The profit margin measures what percent of the total money generated by a company’s services are kept as income.
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Generally, a profit margin of over 10 percent is considered good, but it’s better to compare profit margins within an industry.
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A company generally wants to have a higher profit margin. We can determine if a company’s profit margin is “good” by comparing it with its industry.
Asset Turnover
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Asset Turnover = (Net sales) / (Total assets)
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The asset turnover ratio measures how effectively a company is able to use its assets to generate sales.
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A company generally wants to have a higher asset turnover ratio. We can determine if a company’s asset turnover ratio is “good” by comparing it with its industry.
Equity Multiplier
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Equity Multiplier = (Total assets) / (Total shareholders’ equity)
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The equity multiplier measures the amount of a company’s assets that are financed by shareholders. (Shareholders’ equity = Total assets - Total liabilities).
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A company generally wants to have a lower equity multiplier. We can determine if a company’s equity multiplier is “good” by comparing it with its industry.
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Investors use the equity multiplier to assess risk.
Conclusion
By breaking the ROE into these three components, we may identify the root causes for changes in it.