What Is Dupont Analysis?
DuPont Analysis is a financial ratio analysis that breaks down a company’s return on equity (ROE) into its contributing factors to better understand its financial performance. The ROE is decomposed into several key metrics, such as profitability, leverage, and efficiency, allowing a more informed evaluation of the company’s financial health and future potential.
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The origin of DuPont analysis is associated with the DuPont Corporation, a U.S. chemical and industrial conglomerate. It is widely accepted that the company developed DuPont analysis in the early 20th century and became widely used as a financial analysis tool in the 1920s. Furthermore, it applies to any company, regardless of its size, industry, or location, that has financial statements and ROE data available.
Table of contents
- What Is Dupont Analysis?
- Dupont Analysis Explained
- Equation
- Examples
- Importance
- Limitations
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- DuPont analysis is a tool for dissecting a company’s return on equity (ROE) into its underlying components to better understand its financial performance.
- It evaluates the contribution of different factors, such as profitability, leverage, and efficiency, to a company’s ROE.
- DuPont analysis is used by investment analysts, portfolio managers, banks, financial institutions, regulators, and company managers to evaluate a company’s financial health and future potential.
- It is useful for comparing companies’ financial performance and making informed investment decisions.
DuPont Analysis Explained
DuPont analysis of ROE is an effective tool at the disposal of investors. Moreover, this model can be valuable for fundamental and technical analysis. However, what makes it different? Or, what’s the logic behind it? Let’s understand that first.
Consider a parameter, such as revenue. It is the product of total sales quantity and unit price. Thus, the revenue increases with a proportionate increase in quantity and price. Alternatively, a more than proportional increase in quantity or price would be sufficient and produce similar results.
An average investor would consider only the highest revenue. However, they need to understand that the revenue could be a product of an exorbitantly high unit price and a lower sales quantity and should check for it. If the sales are down, they should ask why the sales are down. Have the sales been low historically, and yet the firm has managed to maintain revenue growth? If not, it is better not to choose the option.
The above scenario explains the logic behind the DuPont analysis interpretation. It breaks the ROE into smaller parts and examines each of these parts. It is chosen if each factor yields adequate results and contributes to a desirable final value. Therefore, it moves away from the basic ROE formula of net income by equity and makes it more inclusive and comprehensive.
Equation
The DuPont analysis formula is in two categories: 3-step and 5-step. Let’s look at them in detail. The former is the original version, and the latter is an extension.
The basic DuPont model equation is:
ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
This formula forms the base of the 3-step and 5-step analyses.
1. 3-Step DuPont Analysis
In a three-step DuPont analysis, the ROE is measured using three components:
ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
- Net Profit Margin (NPM): Net profit margin (NPM) is a financial ratio that measures a company’s profitability by dividing its net profit by its total revenue (Net income by sales). NPM shows the company’s net profit as a percentage of its total sales.
- Asset Turnover: The asset turnover ratio measures a company’s efficiency in generating sales from its assets. It is calculated by dividing the company’s total sales by its total assets. The asset turnover ratio provides insight into how effectively a company utilizes its assets to generate revenue.
- Equity Multiplier: The equity multiplier is a financial ratio that measures a company’s financial leverage or the extent to which it finances its assets through debt. It is calculated by dividing the company’s total assets by shareholder equity. The equity multiplier provides insight into the proportion of a company’s assets that are financed by debt as opposed to equity.
Thus, rather than using the conventional formula and arriving at the ROE, it is possible to decompose ROE into smaller fractions and analyze each parameter for more clarity and in-depth understanding.
2. 5-Step DuPont Analysis
The 5-step DuPont analysis derivation can be a bit complicated. To arrive at the 5-step DuPont formula, take the 3-step DuPont formula and break down the net profit margin formula by replacing the net income with EBT minus Tax since EBT minus Tax gives net income.
Examples
Here are some examples to understand the analysis better.
Example #1
The following table shows a 3-step DuPont analysis of two companies:
| Parameter | Green Co. | Red Co. |
| Net Income | $2000 | $2300 |
| Sales | $12900 | $13400 |
| Net Profit Margin | 0.155 | 0.171 |
| Total Assets | $6000 | $5600 |
| Asset Turnover | 2.15 | 2.39 |
| Equity | $3000 | $4000 |
| Equity Multiplier | 2 | 1.4 |
| ROE | 66.65% | 57.21% |
Example #2
Here is a DuPont analysis of the multinational food and drinks corporation Nestlé. Its comparison is made with two of its competitors Tyson Foods and Kraft Heinz, over the years.
- The net profit margin of Nestlé is higher than both the competitors.
- The asset turnover ratio is higher than Kraft Heinz but lesser than Tyson Foods.
- The equity multiplier is not significantly higher than both competitors.
- The return on equity has increased by over 85% from 2016.
- Further, the company’s stock price has appreciated over the years.
- The company also has a P/E ratio of more than 26, and its quick ratio is 63%.
Importance
Investors consider many ratios and parameters before choosing which company to invest in. They compare multiple companies and even analyze their performance over the years based on these parameters. However, comprehensiveness is key. What are these ratios, and what affects their value? Thus, the DuPont model confers due emphasis on the metrics at the most basic level.
The comparison of metrics can be much more reliable using this method rather than the most common and conventional screening parameters used by most investors. Therefore, the DuPont model helps in decision-making. The investors and firms can follow the DuPont model to understand the pain points and where they might lose prospective investors.
It also helps identify which efficiency (operational, asset use, etc.) is higher for a firm. The three key metrics – net profit margin, asset turnover ratio, and the equity multiplier should all have a satisfactory value, as a result of which the ROE is higher, and not because anyone of these is exorbitantly high; the rest are low. Such an analysis can be done with the DuPont model.
Limitations
Despite the DuPont model’s comprehensiveness, the calculation depends on the initial numbers. Thus, it can be subject to manipulation, and there would be no point in conducting any analysis. In addition, the individual parameters are subject to many forces – such as industry, season, etc.
These considerations are not accounted for in the analysis. Hence, even if a company is profitable in the long run (or yearly), considering the ratios from a short-term perspective might make investors lose out on any future gains.
Frequently Asked Questions (FAQs)
DuPont analysis interpretation can be made in two ways: the 3-step model or the 5-step model. Each of these models involves breaking up the ROE into constituent factors and analyzing them individually. When each parameter falls into a desirable range, the final value, too, becomes desirable.
The DuPont model shows the roots of a firm’s profitability based on the return on equity. It compares the performance of multiple companies and indicates the strengths and weaknesses of a particular company. It also determines the operational and asset use efficiency and a firm’s financial leverage.
In general, a higher ratio is preferable. However, it should be noted that management may lower pricing to increase sales, which would lower net profit. Cost-effective businesses (like Wal-Mart) have employed this tactic quite well. Turnover of Assets (Sales/Total Assets).
Recommended Articles
This article has been a guide to what is Dupont Analysis. We explain its examples, importance, equations (3-step and 5-step), and limitations. You may also find some useful articles here –
- Ratio Analysis
- DuPont Formula
- ROE vs ROA
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
