What is DuPont Analysis
DuPont analysis (also known as the "DuPont identity") is framework for analyzing fundamental performance popularized by the DuPont Corporation. DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). Decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses.
BREAKING DOWN DuPont Analysis
There are three major financial metrics that drive return on equity (ROE): operating efficiency, asset use efficiency and financial leverage. Operating efficiency is represented by net profit margin or net income divided by total sales or revenue. Asset use efficiency is measured by the asset turnover ratio. Financial leverage is equal to average assets divided by average equity.
ROE can be broken down into these three factors as follows:
DuPont Analysis Components
DuPont analysis breaks ROE into its constituent components to determine which of these factors are most responsible for changes in ROE.
Net margin is the ratio of bottom-line profits compared to total revenue or total sales. This is one of the most basic measures of profitability. One way to think about net margin is to imagine a store that sells a single product for $1.00. After the costs associated with buying inventory, maintaining a location, paying employees, taxes, interest and other expenses, the store owner keeps $0.15 in profit from each unit sold. That means the owner's profit margin is 15%, which can be calculated as follows:
The profit margin can be improved if costs for the owner were reduced or if prices were raised, which can have a large impact on ROE. This is one of the reasons that a company's stock will experience high levels of volatility when management makes a change to its guidance for future margins, costs and prices.
Asset Turnover Ratio
The asset turnover ratio measures how efficiently a company uses its assets to generate revenue. Imagine a company had $100 of assets and it made $1,000 of total revenue last year. The assets generated 10 times their value in total revenue, which is the same as the asset turnover ratio and can be calculated as follows:
A normal asset turnover ratio will vary from one industry group to another. For example, a discount retailer or grocery store will generate a lot of revenue from its assets with a small margin, which will make the asset turnover ratio very large. On the other hand, a utility company owns very expensive fixed assets relative to its revenue, which will result in an asset turnover ratio that is much lower than that of a retail firm.
The ratio can be helpful when comparing two companies that are very similar. Because average assets include components like inventory, changes in this ratio can signal that sales are slowing down or speeding up earlier than it would show up in other financial measures. If a company's asset turnover rises, its ROE will improve.
Financial leverage, or the equity multiplier, is an indirect analysis of a company's use of debt to finance its assets. Assume a company has $1,000 of assets and $250 of owner's equity. The balance sheet equation will tell you that the company also has $750 in debt (assets – liabilities = equity). If the company borrows more to purchase assets, the ratio will continue to rise. The accounts used to calculate financial leverage are both on the balance sheet, so analysts will divide average assets by average equity rather than the balance at the end of the period, as follows:
Most companies should use debt with equity to fund operations and growth. Not using any leverage could put the company at a disadvantage compared with its peers. However, using too much debt in order to increase the financial leverage ratio – and therefore increase ROE – can create disproportionate risks.
Using DuPont Analysis
An investor has been watching two similar companies, SuperCo and GearInc, that have recently been improving their return on equity compared to the rest of their peer group. This could be a good thing if the two companies are making better use of assets or improving profit margins.
In order to decide which company is a better opportunity, the investor decides to use DuPont analysis to determine what each company is doing to improve its ROE and whether that improvement is sustainable.
As you can see in the table, SuperCo improved its profit margins by increasing net income and reduced its total assets. SuperCo's changes improved its profit margin and asset turnover. The investor can deduce from the information that SuperCo also reduced some of its debt since average equity remained the same.
Looking closely at GearInc, the investor can see that the entire change in ROE was due to an increase in financial leverage. This means GearInc borrowed more money, which reduced average equity. The investor is concerned because the additional borrowings didn't change the company's net income, revenue or profit margin, which means the leverage may not be adding any real value to the firm.
DuPont Analysis Summary
A DuPont Analysis is used to evaluate the component parts of a company's return on equity (ROE). This allows an investor to determine what financial activities are contributing the most to the changes in ROE. An investor can use an analysis like this to compare the operating efficiency of two similar firms. Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed.