Capital preservation often takes precedence over profit realisation for stock market investors. Therefore, most investors prefer quality stocks. But, in order to identify and invest in quality stocks, investors need to research to get valuable insights and check the performance of different companies.
There are several ratios used to evaluate and compare the financial performance of stocks against set standards or benchmarks. The DuPont Analysis is a powerful and popular method to do so.
Investors and financial advisors often use the DuPont model based on return on equity (ROE) analysis. It helps them to know about the influencing factors of a company’s ROE.
Read on to find out what DuPont Analysis is and why it’s important, how to calculate it and the benefits and drawbacks of this popular evaluation methodology.
DuPont analysis, or DuPont Model, is a multi-step equation that helps to get insights into a company’s performance. This is an extended examination of a company’s ROE that analyses its profitability, asset turnover, and equity multiplier.
The Du Pont analysis deals with the key financial metrics that affect a company’s ROE. It breaks down the different ROE components. This breaking down helps investors separately define key indicators of financial success and identify a company’s strengths and weaknesses.
In other words, it helps investors to analyse how companies can provide higher returns to their shareholders. This model was developed at the American chemical company DuPont Corporation in 1920.
DuPont analysis is a helpful technique used to segregate a business’s different drivers of ROE. It allows analysts to determine financial activities that contribute the most to the shifts in ROE. Using this analysis, investors can compare the operational efficiency of various corporations serving in the same industry.
The DuPont approach is important for investors because return on equity is a significant aspect that an investor considers to evaluate the performance of an investment. The DuPont Analysis allows them to understand a company’s strengths and weaknesses to profitability.
Following is the formula to calculate the Dupont equation.
The DuPont formula is the expanded ROE formula. This expansion of the DuPont formula considers three ROE driving factors:
The Du Pont Chart contains these three factors to evaluate how a company can effectively increase its ROE by holding a high-profit margin, improving asset turnover and leveraging its assets.
The DuPont Analysis Formula is as follows:
Let us elaborate on these components of the ROE DuPont formula.
Net profit margin is a ratio to check the company’s profitability and calculate its operating efficiency. It is a ratio that depicts the profit percentage remaining after deducting expenditures. It is the result of dividing a company’s net profits by its total revenues.
A company’s ROE increases with the increase in its net profit margin. A company can boost its profit margins by decreasing its operational costs or/and raising its prices.
Total asset turnover is a ratio that signifies asset efficiency. It shows how efficiently a company is using its assets to increase sales or revenue. The ratio is calculated by dividing a company’s sales by its total assets. With an increase in the total asset turnover ratio, its ROE also increases.
This ratio is inversely impacted by its net profit margin. The higher the net profit margin, the lower is its asset turnover ratio, and vice versa. It helps investors to compare a business with a high-profit, low-volume business model of two similar companies. They can determine which company is good at driving ROE for them.
The equity multiplier computes a company’s financial leverage. It is a portion of a company’s ROE that results from debt. It is an analysis of a company’s debt to its assets. It is the result of dividing a company’s total assets by its shareholders’ equity. With an increase in the financial leverage of the company, its ROE also increases. Not using any leverage is a disadvantage for a business. However, too much debt can create excessive risks.
A company can use debt financing to fund its operations and growth perspectives. It will keep its equity multiplier at a low level. It is a common practice to boost a company’s ROE with excessive debt.
The DuPont equation gives a broader view of the ROE of a business. It highlights the tailwinds and identifies areas with scope for improvement. Let’s suppose a company’s shareholders are disappointed with its lower ROE. Using the DuPont Analysis, the company can evaluate the reason behind the lower ROE – whether it is due to low-profit margin, low asset turnover, or inadequate leverage. After finding the weak area, the company’s management may take corrective steps.
That being said, a low ROE does not mean a company is weak because it may be the result of normal business operations. The ROE may decline due to increased depreciation in the initial period.
Let us determine the ROE of two companies in the telecom industry having the same ROE of 20%. The breakup of the ratio to calculate DuPont analysis for the two companies are as follows –
|Ratio||Company X||Company Y|
|Net Profit Margin||20%||15%|
|Total Asset Turnover||0.2x||1.1x|
Both companies in this DuPont Analysis example have the same ROE, but the operations of the companies and the performance of the individual component ratios are totally different.
Thus, the DuPont Analysis helps investors determine the performance of similar businesses with similar ratios. They can measure the risk involved in the business model of different companies to make informed investment decisions.
Here are a few key questions you can ask while evaluating and selecting business performance using the DuPont model using the example shared above.
These are the examples of a few key questions that an analyst can ask during evaluating a company using the DuPont interpretations. These questions could help investors to draw informed conclusions about the company, its operations, revenue model, profitability, positives in the balance sheet and other important financial metrics of growth. Such important aspects might not be clear by considering the ROE as a standalone metric.
The DuPont analysis method also helps to compare the change in ROE in different periods and benchmark the company’s performance with competitors in the industry.
The DuPont analysis is very important for an investor and the company itself as it helps in determining what actually is impacting the ROE. A company can increase its Return on Equity if –
From the perspective of investors, the increased Net Profit Margin of a company without any shift in the Financial Leverage indicates that the company’s profitability will increase. But if the company’s ROE has increased due to an increase only in its Financial Leverage, there could be a high risk associated with the company as it is able to increase its assets using debt financing. Thus, the DuPont analysis helps to know whether the ROE is increased with positive signs like increased Net Profit Margin or Asset Turnover Ratio or due to alarming signs like only high leverage.
Ans. It is a method that helps to gain deep insights into the company’s profitability through internal accruals, debt financing or equity. It also helps analysts to understand the weaknesses and strengths of multiple companies in the same industry.
Ans. The DuPont analysis helps investors to understand the key components that help businesses drive profitability. The analysis also helps in identifying the top-performing companies in a sector.
Ans. Although DuPont has many benefits, it has its disadvantages too. If a company is debt-free, you can use DuPont Analysis to understand its profitability.
Ans. No, a zero-debt company cannot be analysed using the DuPont model because it involves financing components.
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