Sep 29, 2022 11:52 PM - Jack Dalton
In 1930, the DuPont corporation aimed to find a platform that could provide a detailed assessment of any company's profitability. The model they developed is aptly termed DuPont analysis; it helps you avoid distracting evaluations of any company's probability. The basic ROE (Return on Equity) formula is widely employed to deal with the nuances of the company's assessment. However, this formula can be misleading as it does not break down the different components of ROE. DuPont Analysis aims to distill ROE into its core components and hence allow analysts to better assess potential ROE. However, the caveat with such a detailed analysis that requires so many inputs is the insight is only as reliable as the data provided, and always keep in mind that financial ratios are almost only useful when being used in comparison with other firms and industry averages.
So to avoid an erroneous conclusion based on ROE calculations, we need more in-depth analysis. In this article, we will cover the following:
DuPont analysis, also termed as the Dupont model or Dupont identity, is "a framework that analyzes the fundamental performances that are popularized by the DuPont corporation" (Investopedia). Dupont analysis is an analytical methodology used to break down the various components of ROE (Return on equity). Distilling ROE into crucial elements allows investors to identify the specific strengths and weaknesses of a company by focusing on the key metrics of financial performance as individual measures.
As we will see, this form of analysis is beneficial to both managers and investors alike. For managers, it allows them to better understand the financial strengths and weaknesses of their company, and for investors it enables them to more accurately evaluate the financial strength of two firms side-by-side.
DuPont analysis is considered an expanded return from the equity formula. It is calculated by multiplying net profit margin by equity by the asset turnover.
DuPont Analysis = Net Profit Margin × Asset Turnover × Financial Leverage
Net Profit Margin = Revenue of a company x net income of a company
Asset Turnover (AT) = average total assets of a company x sales generated by the company
Financial Leverage (FL) = an average shareholders equity x average total assets held by the company
Calculating return on equity allows investors to see how much money they are making on their investment into a company. However, the basic formula leaves a lot to interpretation because it doesn't get into all the drivers of ROE. DuPont analysis uses mathematical manipulation to expand return on equity into three core components. In doing so, it allows investors to pinpoint the strengths of a company and also provides early warning signs to any potential weaknesses. Looking at year to year, comparisons of this analysis can also give investors insight into how management strategy is being played out. Fundamentally, it allows investors to understand the key drivers of ROE and provides signals for where to dig deeper into a company's financial statements.
DuPont analysis breaks down the ROE into three constituent components with which one can accurately estimate the factor that is significantly contributing to the change in ROE. There are three components Dupont is divided.
Net profit margin, also termed as the net margin, is equivalent to the profit or net income generated as a percentage of revenue. It is a ratio of net profits to the revenue of any company. The net profit margin can be expressed in percentage as well in decimal form. It helps the investors in determining whether a company is generating enough revenue from its sales and also helps determine whether or not the operational and overhead costs are being contained or not. In short, it can be said that the net profit margin is a crucial indicator of any company's financial health.
Net profit margin = ( R- COGS - E - I - T / Revenue) x 100
The asset turnover ratio is a "measure of a company's sales or its revenues relative to the value of its assets”. (investopedia) The ratio is a significant indicator that determines the proficiency with which a company is making use of its assets to skyrocket its revenues.
A higher asset turnover ratio indicates that the company is efficiently using its assets in generating revues and vice versa. A company's asset turnover ratio is significantly impacted by asset's purchases and the tremendous asset sales within a year.
Asset turnover = (total sales/ ( beg. sales + end. sales)) x 2
The total sale is equivalent to the annual sales of a company. Beginning and ending sales indicate sales at the start and end of the year.
A leverage ratio acts as a financial measurement that reflects how much of a company's capital is derived from loans or debts. Thus, it assesses the company's ability to meet its financial demands. The leverage ratio is indispensable for investors because companies as they rely on a mixture of debt and equity for financing their operations. If one knows the value of debt a company holds, it would be easy to evaluate whether the company can pay its debts as they come due.
Financial leverage = average assets/ average equity
DuPont analysis is an analytical technique that breaks a relatively simple but shallow formula into a more involved but insightful piece of analysis. Specifically, it splits return on equity into a multiplication of Net Profit Margin, Asset Turnover, and Financial Leverage. This allows investors to understand what is powering the potential return on investment and therefore make a better investment decision.
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