DuPont analysis

Last updated
Graphical representation of DuPont analysis. DuPontModelEng.svg
Graphical representation of DuPont analysis.

DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont framework, DuPont model, DuPont method or DuPont system) is a tool used in financial analysis, where return on equity (ROE) is separated into its component parts.

Contents

Useful in several contexts, this "decomposition" of ROE allows financial managers to focus on the key metrics of financial performance individually, and thereby to identify strengths and weaknesses within the company that should be addressed. [1] Similarly, it allows investors to compare the operational efficiency of two comparable firms. [1]

The name derives from the DuPont company, which began using this formula in the 1920s. A DuPont explosives salesman, Donaldson Brown, submitted an internal efficiency report to his superiors in 1912 that contained the formula. [2]

Basic formula

The DuPont analysis breaks down ROE into three component parts, which may then be managed individually:

ROE = (Profit margin)×(Asset turnover)×(Equity multiplier) = ⁠ Net profit / Sales ⁠×⁠ Sales / Average Total Assets ⁠×⁠ Average Total Assets / Average Equity ⁠ = ⁠Net Profit/Equity⁠

Or

ROE = ⁠Profit/Sales⁠×⁠Sales/Assets⁠ = ⁠Profit/Assets⁠×⁠Assets/Equity⁠

Or

ROE = ROS×AT = ROA×Leverage

ROE analysis

The DuPont analysis breaks down ROE (that is, the returns that investors receive from a single dollar of equity) into three distinct elements. This analysis enables the manager or analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). See Return on equity § The DuPont formula for further context.

The DuPont analysis is less useful for industries such as investment banking, in which the underlying elements are not meaningful (see related discussion: Valuation (finance) § Valuing financial services firms). Variations of the DuPont analysis have been developed for industries where the elements are weakly meaningful,[ citation needed ] for example:

High margin industries

Some industries, such as the fashion industry, may derive a substantial portion of their income from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may be critical. The DuPont analysis allows analysts to determine which of the elements is dominant in any change of ROE.

High turnover industries

Certain types of retail operations, particularly stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under-, or, over-performance. For example, same-store sales of many retailers is considered important as an indication that the firm is deriving greater profits from existing stores (rather than showing improved performance by continually opening stores).

High leverage industries

Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. Other industries would see high levels of leverage as unacceptably risky. DuPont analysis enables third parties that rely primarily on their financial statements to compare leverage among similar companies.

ROA and ROE ratio

The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover. [3]

The return on equity (ROE) ratio is a measure of the rate of return to stockholders. [4] Decomposing the ROE into various factors influencing company performance is often called the DuPont system. [5]

Where
  • Net Income = pre-tax income after taxes
  • Equity = shareholders' equity
  • EBIT = Earnings before interest and taxes
  • Pretax Income is often reported as Earnings Before Taxes or EBT

This decomposition presents various ratios used in fundamental analysis.

Related Research Articles

<span class="mw-page-title-main">Economic value added</span> Value of a firms profit after deduction of capital costs

In accounting, as part of financial statements analysis, economic value added is an estimate of a firm's economic profit, or the value created in excess of the required return of the company's shareholders. EVA is the net profit less the capital charge ($) for raising the firm's capital. The idea is that value is created when the return on the firm's economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice, only several key ones are made, depending on the company and its industry.

<span class="mw-page-title-main">Revenue</span> Total amount of income generated by the sale of goods or services

In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive revenue from interest, royalties, or other fees. "Revenue" may refer to income in general, or it may refer to the amount, in a monetary unit, earned during a period of time, as in "Last year, company X had revenue of $42 million". Profits or net income generally imply total revenue minus total expenses in a given period. In accounting, revenue is a subsection of the equity section of the balance statement, since it increases equity. It is often referred to as the "top line" due to its position at the very top of the income statement. This is to be contrasted with the "bottom line" which denotes net income.

<span class="mw-page-title-main">Income statement</span> Type of financial statement

An income statement or profit and loss account is one of the financial statements of a company and shows the company's revenues and expenses during a particular period.

Stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value. A target price is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings.

In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses except interest expenses and income tax expenses.

<span class="mw-page-title-main">Net income</span> Measure of the profitability of a business venture

In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.

Profit margin is a financial ratio that measures the percentage of profit earned by a company in relation to its revenue. Expressed as a percentage, it indicates how much profit the company makes for every dollar of revenue generated. Profit margin is important because this percentage provides a comprehensive picture of the operating efficiency of a business or an industry. All margin changes provide useful indicators for assessing growth potential, investment viability and the financial stability of a company relative to its competitors. Maintaining a healthy profit margin will help to ensure the financial success of a business, which will improve its ability to obtain loans.

The return on assets (ROA) shows the percentage of how profitable a company's assets are in generating revenue.

In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income to net sales, usually expressed in percent.

Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is.

In finance, leverage, also known as gearing, is any technique involving borrowing funds to buy an investment.

The return on equity (ROE) is a measure of the profitability of a business in relation to its equity; where:

<span class="mw-page-title-main">Contribution margin</span> Unit selling price minus its variable cost

Contribution margin (CM), or dollar contribution per unit, is the selling price per unit minus the variable cost per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. This concept is one of the key building blocks of break-even analysis.

Return on capital employed is an accounting ratio used in finance, valuation, and accounting. It is a useful measure for comparing the relative profitability of companies after taking into account the amount of capital used.

<span class="mw-page-title-main">Financial statement analysis</span>

Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, valuation, financial health, and future prospects of an organization.

The following outline is provided as an overview of and topical guide to finance:

In finance, asset turnover (ATO), total asset turnover, or asset turns is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company. Asset turnover is considered to be a profitability ratio, which is a group of financial ratios that measure how efficiently a company uses assets. Asset turnover can be furthered subdivided into fixed asset turnover, which measures a company's use of its fixed assets to generate revenue, and working capital turnover, which measures a company's use of its working capital to generate revenue. Total asset turnover ratios can be used to calculate return on equity (ROE) figures as part of DuPont analysis. As a financial and activity ratio, and as part of DuPont analysis, asset turnover is a part of company fundamental analysis.

According to PIMS, an important lever of business success is growth. Among 37 variables, growth is mentioned as one of the most important variables for success: market share, market growth, marketing expense to sales ratio or a strong market position.

<span class="mw-page-title-main">Financial ratio</span> Numerical value to determine the financial condition of a company

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are publicly listed, the market price of the shares is used in certain financial ratios.

References

  1. 1 2 Marshall Hargrave (2022). Dupont Analysis, Investopedia.
  2. ↑ Phillips, Matt (9 December 2015). "The DuPont invention that changed how things work in the corporate world". Quartz (publication) . Retrieved 9 December 2015.
  3. ↑ Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc. pp. 444–445. ISBN   0-7641-1275-9.
  4. ↑ Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc. p. 444. ISBN   0-7641-1275-9.
  5. ↑ Bodie, Zane; Alex Kane; Alan J. Marcus (2004). Essentials of Investments, 5th ed. McGraw-Hill Irwin. pp. 458–459. ISBN   0-07-251077-3.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.