It was 1912, and Donaldson Brown was working as an explosives salesman for the DuPont Corporation. About that time, the company treasurer John Raskob brought him into the financial activities of the company and encouraged him to use statistics to evaluate the business performance of the various activities under the DuPont corporation.
Pierre du Pont, who later became Brown’s mentor, was one of the first company executives that can be seen as a CFO in the way we now understand this role, and he encouraged his subordinates, including Brown, to analyze performance in creative new ways, embracing scientific and statistical techniques.
Donaldson invented a formula in an internal efficiency report in the same year, which the company started to use in the 1920s. This formula was what we now refer to as the DuPont Model (also known as DuPont analysis, DuPont method, DuPont formula, DuPont identity, etc.).
Profitability and Return on Equity
Profitability is one of the measurements of efficiency and whether it is successful or not. It can also be defined as the ability of the business to produce a return on the investment based on available resources, which is comparable to an alternative investment.
As discussed in our Financial Ratios Analysis article Return on equity, or ROE, measures the financial performance by dividing net income over shareholders’ equity. Because shareholders’ equity equals assets minus debt, ROE also represents the return on net assets.
ROE shows us how effectively management is employing the company’s assets to create profit.
The DuPont equation breaks down Return on Investment in three distinct elements. This way, we can compare the company to other companies in similar industries and better understand the circumstances that influence the metric.
The basic DuPont model consists of the following formula:
When we represent those elements as ratios, we get:
We can look at these components individually, and this way analyze the source of the company’s Return On Equity. This helps us perform a better benchmarking analysis against its competitors.
Let’s take a look at the three elements and how they tie together in the DuPont model.
Net Profit Margin
As we discussed in previous articles, the Net Profit Margin is among the most common profitability measures. It compares the bottom line of the income statement to the total sales or revenue of the company.
To improve the net profit margin, we can try to increase sales prices or to reduce the costs for the company, which will have a significant impact on ROE and stock levels.
Assets Turnover Ratio
Looking at the assets turnover ratio, we can analyze how efficiently management is using the company’s assets to generate revenue.
This metric differs a lot between industry groups. As an example, a mobile network has a large and expensive set of fixed assets compared to its revenue, which will result in a low assets turnover ratio. On the other hand, a retailer will generate a lot of low-margin sales from its assets, which will make the ratio very large.
The equity multiplier, or the financial leverage ratio, is an indirect way to evaluate the company’s use of debt to finance its assets. Analyzing assets and equity and looking at the basic equation that assets = equity + liabilities we see how much debt the company has and we can notice that if a company increases its debt to acquire more assets, the equity multiplier will continue to rise.
To see how we can employ the DuPont model to understand the drivers behind the increase in ROE better, let us look at an example.
We have two companies that we consider as possible investment opportunities. Both companies are doing better than their peer groups and have increased their return on equity from 8% to 13% in the last year. Such an increase can be good if it is due to increased profit margins or better use of assets.
We calculate ROE via the DuPont model and look at how it changes over the analyzed periods.
What we can immediately notice is that both companies keep the same profit margins. However, ACME Inc. increased it’s Asset Turnover from 0,56 to 0,75, which means that management is using the company assets better. This resulted in an increase of ROE from 8% to 13%.
On the other hand, Umbrella Corp. has kept the same Assets Turnover ratio but has increased it’s financial leverage, by increasing the equity multiplier from 3,19 to 5,42.
Such development should raise a red flag. It appears that the additional borrowings did not help the company increase the profit margin or the Asset Turnover ratio, which brings up the question if the extra leverage is adding any real value to the business.
Therefore in the current scenario, it looks like ACME Inc. is a better investment opportunity.
It is important to note that the DuPont analysis formula is still the ROE, just an expanded version of the return on equity metric. The ROE (Return On Equity) calculation shows us how well the management is using shareholders’ capital. The DuPont model helps analysts and investors to understand what drives the changes in ROE. Breaking down the model can show us if profitability, use of assets, or debt is influencing ROE more.
The DuPont method faces the same limitations as all ratio analysis. It depends on the underlying accounting data, which can be erroneous or manipulated.
Keeping that in mind, the DuPont model is a useful way to break down the different drivers of return on equity (ROE). We can use it to compare similar firms concerning their operational efficiency and to identify areas for improvement that we can address within the business.
That was all you need to start doing DuPont analysis as part of your financial and business analysis. The template from the example is also available for download here:
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