Breaking return on equity into margin, asset turnover and leverage, so you can see which of the three is driving the number.
The three-step version multiplies net-margin by asset turnover (revenue over assets) by the equity multiplier (assets over equity). A five-step version splits margin further into tax burden, interest burden and operating-margin.
The value is diagnostic. Two companies at 14% return-on-equity can be a high-margin, low-turnover, unleveraged business and a thin-margin, fast-turning, heavily leveraged one. They are not the same investment.
Example: Northwind Tools has a 9.3% net margin, 0.57 asset turnover and a 2.6 equity multiplier: 9.3% times 0.57 times 2.6 gives 13.7% ROE, with leverage supplying more than half of it.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
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