DuPont analysis (also known as the DuPont identity, DuPont Model or the DuPont method) is an expression which breaks ROE (Return On Equity) into three parts.
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Basic formula
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)
- Operating efficiency (measured by profit margin)
- Asset use efficiency (measured by asset turnover)
- Financial leverage (measured by equity multiplier)
ROE analysis
The Du Pont identity breaks down Return on Equity (that is, the return to equity that investors have contributed to the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries).
The Du Pont identity, however, is less useful for some industries, such as investment banking, that do not use certain concepts or for which the concepts are less meaningful. Variations may be used in certain industries, as long as they also respect the underlying structure of the Du Pont identity.
Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is by definition true.
Examples
High turnover industries
Certain types of retail establishments, particularly stores, may have very low profit margins on sales, and relatively moderate leverage.In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under-, or, over-performance. For example, same store sales of many retailers is considered important as an indication that the firm is deriving greater profits from existing stores (rather than showing improved performance by continually opening new stores).
High margin industries
Other industries, such as fashion, may derive a substantial portion of similar companies.
ROI and ROE ratio
The return on investment (ROI) ratio developed by Du Pont for its own use is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover.[1]
The return on equity (ROE) ratio is a measure of the rate of return to stockholders.[2] Decomposing the ROE into various factors influencing company performance is often called the Du Pont system.[3]
- Where
- Net profit = net profit after taxes
- Equity = shareholders' equity
- EBIT = Earnings before interest and taxes
- Sales = Net sales
This decomposition presents various ratios used in fundamental analysis.
- The company's tax burden is (Net profit ÷ Pretax profit). This is the proportion of the company's profits retained after paying income taxes.
- The company's interest burden is (Pretax profit ÷ EBIT). This will be 1.00 for a firm with no debt or financial leverage.
- The company's operating profit margin or return on sales (ROS) is (EBIT ÷ Sales). This is the operating profit per dollar of sales.
- The company's asset turnover (ATO) is (Sales ÷ Assets).
- The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's debt to equity ratio + 1. This is a measure of financial leverage.
- The company's return on assets (ROA) is (Return on sales x Asset turnover).
- The company's compound leverage factor is (Interest burden x Leverage).
ROE can also be stated as:[4]
-
- ROE = Tax burden x Interest burden x Margin x Turnover x Leverage
- ROE = Tax burden x ROA x Compound leverage factor
Profit margin is (Net profit ÷ Sales), so the ROE equation can be restated:
References
- ^ Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc.. pp. 444–445. ISBN 0764112759.
- ^ Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc.. p. 444. ISBN 0764112759.
- ^ Bodie, Zane; Alex Kane and Alan J. Marcus (2004). Essentials of Investments, 5th ed. McGraw-Hill Irwin. pp. 458–459. ISBN 0072510773.
- ^ Bodie, Zane; Alex Kane and Alan J. Marcus (2004). Essentials of Investments, 5th ed. McGraw-Hill Irwin. p. 460. ISBN 0072510773.
External links
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