Determinants of return-on-equity in USA, German and Japanese manufacturing firms

Introduction

The DuPont system is a popular analytical technique in corporate finance to study the determinants of a firm’s return-on-equity. In the system, the three determinants of return-on-equity (ROE) (net profit/common equity) are net profit margin (NPM) (net profit/sales), total assets turnover (TAT) (sales/total assets) and equity multiplier (EQM) (total assets/common equity). The DuPont method can be used to assess a firm’s financial position by comparing a firm’s ratios to competitors or to the industry average. The method can also be used to conduct historical analyses by investigating changes in a firm’s product pricing, manufacturing costs, asset management and financial leverage and the associated impacts on ROE over time. The model has also been used to conduct predictive analysis, such as corporate failure, bond ratings and credit risk (Mankin and Jewell, 2014).

The objective in this paper is to study the cross-sectional determinants of ROE in USA, German and Japanese manufacturing firms. We examine whether sales profitability, total assets management or use of financial leverage is the most important (or the least important) determinant of ROE in the manufacturing firms of these countries. Our findings in this study may provide valuable insights for financial managers and for global investors who invest in these countries.

DuPont system

The DuPont method of financial statement analysis was first introduced in 1919 by the E.I. DuPont de Nemours company as a means of examining the components of company performance, as measured by ROE. The initial version of this model was:(1) $$\mathrm{Return}\mathrm{on}\mathrm{assets}=\mathrm{Profit}\mathrm{margin}\times \mathrm{asset}\mathrm{turnover}\mathrm{.}$$

This model remained unchanged until 1970, when an EQM was introduced to better reflect the return to common shareholders (ROE), a well-established measure of overall company financial performance. The resulting DuPont model provides an organizing framework for key ratios by breaking ROE down into its component parts – profit margin, asset turnover and the EQM:(2) $$\mathrm{Return}-\mathrm{on}-\mathrm{equity}=\mathrm{Profit}\mathrm{margin}\times \mathrm{asset}\mathrm{turnover}\times \mathrm{equity}\mathrm{multiplier}\mathrm{.}$$

We can easily see the mathematical validity of this equation by defining each component as follows:(3) $$\mathrm{Net}\mathrm{income}/\mathrm{equity}=\mathrm{Net}\mathrm{income}/\mathrm{sales}\times \mathrm{sales}/\mathrm{total}\mathrm{assets}\times \mathrm{total}\mathrm{assets}/\mathrm{equity}\mathrm{.}$$

Thus, the three paths to providing returns to shareholders are...