Introduction:
The DuPont model is a very significant tool for the analysis of a financial evaluation of the organization. It is actually based on three prime parameters that any organization possesses, namely, turnover, liquidity, and profitability.
The DuPont analysis is a formula used to evaluate the financial performance of a company based on its return on equity (ROE). It was developed, by most accounts, by a DuPont executive in 1919. ROE provides the shareholder with an idea of how efficiently a company is using capital from its shareholders. It is calculated by taking the net income of a company and dividing it by the shareholders’ equity.
A DuPont analysis goes one step further and allows an investor to ascertain which financial activities are contributing the most to the changes in ROE. Even an investor can use a DuPont analysis to make a comparison between the operational efficiency of two firms that are similar in nature, whereas company managers can utilize it to identify which aspect is strong and which should be addressed. T
Three primary financial metrics that drive ROE
Operating efficiency refers to a ratio that denotes the net profit margin or net income by total sales or revenue.
Asset usage efficiency as measured by the asset turnover ratio.
Financial leverage is measured by the equity multiplier, which is equal to average assets divided by average equity.
Return on Equity(ROE)
Return on equity (ROE) is one of the highly used accounting ratios that relates to the profitability of a particular company. It highlights profit returned as a percentage with regard to the amount of money invested by the shareholders.
ROE = Net Income / Shareholder Equity
Problem with ROE
If this number increases, then it is expected to be a good sign for the company as it is indicating that the rate of return on shareholders’ equity is increasing. Having a higher return on equity is not always a good sign; however, the ratio itself proves useful in digging deeper into the issue. It can be manipulated intentionally or even unintentionally if a company has a large amount of debt that lowers a shareholder’s proportion of equity.
Other examples would be when net income and shareholders’ equity are negative, meaning a company is doing badly, but by laws of mathematics will give a positive figure of ROE. This is clearly misleading. However, if either net income or equity are negative, they should not be used at all.
Suppose two companies have approximately the same ROI in the same sector. Which company investors should invest in? Here comes the need for Dupont analysis. To avoid any incorrect conclusions based on ROE analysis, we can go for an in-depth analysis of this measure.
Formula for Dupont Analysis
There are two forms of the DuPont analysis: the original three-step equation and an extended five-step equation.
Basic Dupont Model (Three-Step Dupont):
ROE = NPM x Asset Turnover Ratio x Equity multiplier
NPM=net profit margin, the measure of operating efficiency.
Asset turnover is the measure of asset use efficiency.
Equity multiplier = measure of financial leverage
If net profit margin or asset turnover has been increasing, then it is a very positive indicator about the company; however, if such a rise is forming due to equity multiplier, then the corporation was the right size before; it’s just making things riskier.
Stock may deserve a greater discount if the firm gets over-leveraged, despite the increase in ROE. The company may be under-leveraged as well. In that case, it would be positive and show that the company is managing itself better.
Even if a company’s ROE hasn’t changed, analysis in this manner can be very insightful. Assume a company provides numbers and its ROE is unmoved. Analysis with DuPont analysis may demonstrate that both net profit margin and asset turnover were decreased, such that two poor signs for the firm and leverage were the reasons why ROE remained the same. No matter what the situation of the company is at the outset, this would be a bad sign.
Five-Step DuPont
The five-step, or extended, DuPont equation breaks down net profit margin even further. From the three-step equation, we learned that the increase in the net profit margin, asset turnover, and leverage would result in a higher ROE. We can see the five-step equation shows that increases in leverage don’t always indicate an increase in ROE.
ROE = SEBT × A/S × E/A × (1−TR)
EBT = earnings before tax
S=Sales
A=Assets
E=Equity
TR=Tax rate
ROE = (OPM × AT− IER) × EM × TRR
OPM=operating profit margin
AT=Asset turnover
IER=Interest expense rate
EM=Equity multiplier
TRR = Tax retention rate
If the cost of borrowing incurred by the company is high, then more debt would lead to an increased interest expense that would reduce the benefits of the leverage.
Learn the Cause Behind the Effect
Both the three-step and five-step equations help better understand what is changing in a company, rather than one simple ratio in the ROE of a company. As with financial statement ratios, these should always be viewed against the company’s history and its competitors.
For example, analyzing two peer companies, one would have a lower ROE. With this five-step equation, you could determine if this is the case because: creditors view the firm as riskier and charge it higher interest; the company is not well managed and has leverage that is too low; or the company has higher costs that reduce its operating profit margin. Identifying such sources brings better knowledge to the company and how it should be valued.
Conclusion
This makes the DuPont analysis a very useful tool in evaluating components that constitute a company’s ROE calculation.
You could be a stock analyst, an investor, or even a manager, and use a DuPont analysis to help identify what factors might drive a company’s ROE, which can make it easier to spot the causes for any shift in its ROE, as well as compare the financial performance of the company with that of its competitors.
All this needs to be kept in mind is the limits of this formula regarding the quality of the inputs.