What is the 'DuPont Analysis'
DuPont analysis is a method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value to produce a higher return on equity (ROE). It is also known as DuPont identity.
BREAKING DOWN 'DuPont Analysis'According to DuPont analysis, ROE is affected by three things: operating efficiency, which is measured by profit margin; asset use efficiency, which is measured by total asset turnover; and financial leverage, which is measured by the equity multiplier.
DuPont Analysis Components
DuPont analysis breaks ROE into its constituent components to determine which of these components is most responsible for changes in ROE.
Net margin: Expressed as a percentage, net margin is the revenue that remains after subtracting all operating expenses, taxes, interest and preferred stock dividends from a company's total revenue.
Asset turnover ratio: This ratio is an efficiency measurement used to determine how effectively a company uses its assets to generate revenue. The formula for calculating asset turnover ratio is total revenue divided by total assets. As a general rule, the higher the resulting number, the better the company is performing.
Equity multiplier: This ratio measures financial leverage. By comparing total assets to total stockholders' equity, the equity multiplier indicates whether a company finances the purchase of assets primarily through debt or equity. The higher the equity multiplier, the more leveraged the company, or the more debt it has in relation to its total assets.
DuPont analysis involves examining changes in these figures over time and matching them to corresponding changes in ROE. By doing so, analysts can determine whether operating efficiency, asset use efficiency or leverage is most responsible for ROE variations.
Why Gross Book Value Is Used
It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. Using gross book value as opposed to net book value for assets results in a higher ROE, which can factor into a company's decision to purchase new assets.
By contrast, new asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, DuPont analysis helps locate the part of the business that is underperforming.