Dupont Analysis 22473v

DuPont Analysis The DuPont analysis is a modification on calculating return on equity (ROE), but it uses a gross value for assets, where accumulated depreciation is ignored. The DuPont analysis method renders a higher ROE. The DuPont Corporation developed this analysis tool in the 1920’s. The formula is: ROE = Profit Margin x Asset Turnover x Equity Multiplier Profit Margin measures operating efficiency. Asset Turnover measures asset use efficiency – how well did the managers use the assets to generate sales? Finally, the Equity Multiplier measures the amount of financial leverage used by the company. The theory behind using gross asset value instead of net asset value is that it encourages managers to get the most out of the assets. If net asset values are used, ROE is lower because of accumulated depreciation. To make it higher, managers invest in new equipment to make the assets s higher. Basic ROE analysis may provide a misleading ROE. The three-step analysis of ROE used in the DuPont method allows an investor to determine the reason the total ROE number changed. For instance, if the profit margin or asset turnover portions of the ROE increase, then that is a sign of good company management. However, if ROE goes up because the company borrowed more money, thus using a greater amount of financial leverage, this might indicate that the company is a risky investment.

What is the 'DuPont Analysis' DuPont analysis is a method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value to produce a higher return on equity (ROE). It is also known as DuPont identity.

BREAKING DOWN 'DuPont Analysis' According to DuPont analysis, ROE is affected by three things: operating efficiency, which is measured by profit margin; asset use efficiency, which is measured by total asset turnover; and financial leverage, which is measured by the equity multiplier. Therefore, DuPont analysis is represented in mathematical form by the following calculation: ROE = Profit Margin x Asset Turnover Ratio x Equity Multiplier.

DuPont Analysis Components DuPont analysis breaks ROE into its constituent components to determine which of these components is most responsible for changes in ROE.

Net margin: Expressed as a percentage, net margin is the revenue that remains after subtracting all operating expenses, taxes, interest and preferred stock dividends from a company's total revenue. Asset turnover ratio: This ratio is an efficiency measurement used to determine how effectively a company uses its assets to generate revenue. The formula for calculating asset turnover ratio is total revenue divided by total assets. As a general rule, the higher the resulting number, the better the company is performing. Equity multiplier: This ratio measures financial leverage. By comparing total assets to total stockholders' equity, the equity multiplier indicates whether a company finances the purchase of assets primarily through debt or equity. The higher the equity multiplier, the more leveraged the company, or the more debt it has in relation to its total assets. DuPont analysis involves examining changes in these figures over time and matching them to corresponding changes in ROE. By doing so, analysts can determine whether operating efficiency, asset use efficiency or leverage is most responsible for ROE variations.

Why Gross Book Value Is Used It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. Using gross book value as opposed to net book value for assets results in a higher ROE, which can factor into a company's decision to purchase new assets. By contrast, new asset avoidance can occur as financial ing depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, DuPont analysis helps locate the part of the business that is underperforming.

Decoding DuPont Analysis Return on equity (ROE) is a closely-watched number among knowledgeable investors. It is a strong measure of how well a company's management creates value for its shareholders. The number can be misleading, however, as it is vulnerable to measures that increase its value while also making the stock more risky. Without a way of breaking down ROE components, investors could be duped into believing a company is a good investment when it's not. Read on to learn how to use DuPont analysis to break apart ROE and gain a much better understanding about where movements in ROE are coming from. The beauty of ROE is that it is an important measure that only requires two numbers to compute: net income and shareholders' equity. ROE = net income / shareholder's equity If this number goes up, it is generally a good sign for the company as it is showing that the rate of return on the shareholders' equity is rising. The problem is that this number can also rise simply when the company takes on more debt, thereby

decreasing shareholder equity. This would increase the company's leverage, which could be a good thing, but it will also make the stock more risky.

Three-Step DuPont To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In the 1920s the DuPont corporation created an analysis method that fills this need by breaking down ROE into a more complex equation. DuPont analysis shows the causes of shifts in the number. There are two variants of DuPont analysis: the original three-step equation, and an extended five-step equation. The three-step equation breaks up ROE into three very important components: ROE = (net profit margin) * (asset turnover) * (equity multiplier)

These components include: 

Operating efficiency – as measured by profit margin.

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Asset use efficiency – as measured by total asset turnover.

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Financial leverage – as measured by the equity multiplier.

The Three-Step DuPont Calculation Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get: 

ROE = (net income / sales) * (sales / shareholders' equity)

We now have ROE broken into two components: the first is net profit margin and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont identity: 

ROE = (net income / sales) * (sales / assets) * (assets / shareholders' equity)

This equation for ROE breaks it into three widely used and studied components: 

ROE = (net profit margin) * (asset turnover) * (equity multiplier)

We have ROE broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how effectively the company makes use of its assets) and equity multiplier (a measure of how much the company is leveraged). The usefulness should now be clearer. If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the company. However, if the equity multiplier is the source of the rise, and the company was already appropriately leveraged, this is simply making things more risky. If the company is getting overleveraged, the stock might deserve more of a discount despite the rise in ROE. The

company could be under-leveraged as well. In this case it could be positive and show that the company is managing itself better. Even if a company's ROE has remained unchanged, examination in this way can be very helpful. Suppose a company releases numbers and ROE is unchanged. Examination with DuPont analysis could show that both net profit margin and asset turnover decreased, two negative signs for the company, and the only reason ROE stayed the same was a large increase in leverage. No matter what the initial situation of the company, this would be a bad sign.

Five-Step DuPont The five-step, or extended, DuPont equation breaks down net profit margin further. From the three-step equation we saw that, in general, rises in the net profit margin, asset turnover and leverage will increase ROE. The five-step equation shows that increases in leverage don't always indicate an increase in ROE.

The Five-Step Calculation Since the numerator of the net profit margin is net income, this can be made into earnings before taxes (EBT) by multiplying the three-step equation by 1 minus the company's tax rate: 

ROE = (earnings before tax / sales) * (sales / assets) * (assets / equity) * (1 – tax rate)

We can break this down one more time, since earnings before taxes is simply earnings before interest and taxes (EBIT) minus the company's interest expense. So, if a substitution is made for the interest expense, we get: 

ROE = [(EBIT / sales) * (sales / assets) – (interest expense / assets)] * (assets / equity) * (1 – tax rate)

The practicality of this breakdown is not as clear as the three-step, but this identity provides us with: 

ROE = [(operating profit margin) * (asset turnover) – (interest expense rate)] * (equity multiplier) * (tax retention rate)

If the company has a high borrowing cost, its interest expenses on more debt could mute the positive effects of the leverage.

Learn the Cause Behind the Effect Both the three- and five-step equations provide deeper understanding of a company's ROE by examining what is really changing in a company rather than looking at one simple ratio. As always with financial statement ratios, they should be examined against the company's history and its competitors.

For example, when looking at two peer companies, one may have a lower ROE. With the five-step equation, you can see if this is lower because: creditors perceive the company as riskier and charge it higher interest, the company is poorly managed and has leverage that is too low, or the company has higher costs that decrease its operating profit margin. Identifying sources like these leads to better knowledge of the company and how it should be valued.

The Bottom Line A simple calculation of ROE may be easy and tell quite a bit, but it does not provide the whole picture. If a company's ROE is lower than its peers, the three- or five-step identities can help show where the company is lagging. It can also shed light on how a company is lifting or propping up its ROE. DuPont analysis helps significantly broaden understanding of ROE.