How Return on Equity Can Help Guide an Investment Banking Deal - dummies

How Return on Equity Can Help Guide an Investment Banking Deal

By Matt Krantz, Robert R. Johnson

The goal of most businesses and investment bankers in a capitalistic system is to make money for their owners because it’s their money — they provide risky capital. Owners commit money to a company with the expectation that the company will put that money to productive use and that the owner will be handsomely rewarded for this commitment of funds by providing him with a return.

In fact, for years, business students have learned that the overriding goal of the corporation is to maximize shareholder wealth as measured by stock price. Financial markets not only reward individuals that productively use capital but also help to allocate capital to those businesses that consistently earn solid returns on the capital employed. But what are the primary drivers associated with rising stock prices and happy investors?

Companies looking to expand and grow often look to acquire other companies to fuel that growth. And one of the most attractive elements of any acquisition target is its ability to generate a high return on equity. So, investment bankers will scour the markets looking for firms that are able to provide high returns to shareholders and hope that those firms can be purchased at an attractive price.

It isn’t simply the final return on equity number that matters most to a savvy investment banker. Instead, how a company achieves that return on equity is crucial to determining whether a company is an attractive acquisition target.

Is the high return the result of borrowing a lot of money — does leverage fuel the return? Is the return the result of high profit margins, or does it result from modest profit margins and high turnover? These questions are the kind that investment bankers must provide answers to when pitching deals to management. DuPont analysis is a well-established and widely used tool to provide systematic answers to these questions.