How do you calculate the Du Pont Identity?

Answer 1

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 / shareholder's 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 / shareholder's equity) This equation for ROE, breaks it into three widely used and studied components:

* ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier) 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)