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What is 'DuPont Analysis'

DuPont analysis is a fundamental performance measurement framework popularized by the DuPont Corporation and is also referred to as the "DuPont identity." DuPont analysis is a useful technique used to decompose the different drivers of the return on equity (ROE). Decomposition of ROE allows investors to focus their research on the distinct company performance indicators otherwise cursory evaluation.

BREAKING DOWN 'DuPont Analysis'

According to DuPont analysis, there are three major financial metrics 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 average shareholders' equity. Asset use efficiency is measured by total asset turnover or the asset turnover ratio. Finally, financial leverage is analyzed through observation of changes in 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 of the total revenue, 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 return on equity (ROE). By doing so, analysts can determine whether operating efficiency, asset use efficiency or leverage is most responsible for return on equity (ROE) variations.

DuPont Analysis Calculations

Using basic calculations, DuPont analysis breaks down the relationship between return on equity (ROE) and return on assets (ROA) in mathematical form by the following calculation:

Return on Equity (ROE) = Net Income / Average Shareholders' Equity

= (Net Income / Average Total Assets) x (Average Total Assets / Average Shareholders' Equity)

Which then results in the following outcome:

Return on Equity (ROE) = Return on Assets (ROA) x Leverage

Where:

Leverage = Equity Multiplier

Return on Assets (ROA) = Net Profit Margin % x Total Asset Turnover Ratio (ATO)

The more recognizable DuPont analysis formula comes in the following form:

Return on Equity (ROE) = Net Profit Margin x Asset Turnover Ratio x Equity Multiplier.

Which corresponds to the following interpretation:

Return on Equity (ROE) = (Net Income / Average Shareholders' Equity) = (Net Income / Total Revenue) x (Revenue / Average Total Assets) x (Average Total Assets / Average Shareholders' Equity)

To separate the effect of taxes, the return on equity (ROE) decomposition can be interpreted as:

Return on Equity (ROE) = Tax Burden x Interest Burden x EBIT Margin % x Total Asset Turnover Ratio (ATO) x Equity Multiplier

Where:

Net Profit Margin = Tax Burden x Interest Burden x EBIT Margin %

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