Concept 50: DuPont Analysis IFT World

As can be seen below, the 5-steps of the DuPont method cross multiply into the return on equity formula. The various components of the DuPont analysis can be viewed historically in a time series analysis to identify trends and averages to be used in forecasting. We have ROE broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how effectively the company makes use of its assets) and equity multiplier (a measure of how much the company is leveraged). We have ROE broken down into net profit margin or how much profit the company gets out of its revenues, asset turnover or how effectively the company makes use of its assets, and equity multiplier which is a measure of how much the company is leveraged. The five-step, or extended, DuPont equation breaks down net profit margin further.

You can use it to compare the operational efficiency of two similar firms, as it allows you to see what financial activities are contributing the most to the changes in ROE. The DuPont analysis breaks down Return on Equity (ROE) into its constituent components, helping you determine which factors are most responsible for changes in ROE. The 5-Step DuPont Analysis is an extension of the standard DuPont equation, which was created by Donaldson Brown in 1912. Brown’s formula has been widely adopted and respected for its mathematical precision and strengths. The 5-Step DuPont Analysis is an extension of the standard DuPont equation, breaking down Return on Equity (ROE) into five components.

• Without a way of breaking down ROE components, investors could be duped into believing a company is a good investment when it’s not.
• The Extended version of the DuPont analysis further breaks down the profit margin by including tax rates and interest expenses separately.
• The 5-Step DuPont Analysis is an extension of the standard DuPont equation, which was created by Donaldson Brown in 1912.
• In order to achieve a high ROE, a company must reduce its interest expense such that the EBT/EBIT ratio is high.

Extended DuPont Analysis of Return on Equity – CFA Level I

Originally devised in the 1920s by Donaldson Brown at DuPont Corporation, the chemical company, the model is used to analyze the return on equity (ROE) as broken down into different parts in order to analyze the contribution of each part. ROE is vulnerable to measures that increase its value while also making the stock riskier. Investors could be duped into believing a company is a good investment when it’s not without a way of breaking down ROE components, DuPont analysis can break apart ROE and lead to a much better understanding of where movements in ROE are coming from. The DuPont analysis can be used to examine the different drivers of return on equity for a business, such as the impact of leverage on return on equity.

The DuPont corporation created an analysis method in the 1920s that fills this need. Allied Business Academies publishing a total of 14 different journals in various fields of business. The effect of certain competitive advantages over a company’s profitability (Dehning & Stratopoulos, 2002). Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own.

Dupont Analysis Example

DuPont decomposition of return on equity (ROE) identifies the drivers of a company’s ROE in terms of EBIT margin, interest burden, tax burden, total asset turnover ratio and financial leverage ratio. In order to achieve high ROE, a company must increase its EBIT margin, decrease its interest expense and taxes, increase its asset utilization and include more debt in its capital structure. Fifth, the financial leverage involves a cost that needs to be paid and leaves the remaining profits for taxation (EBT/EBIT), and that is the one previously explained under the TA/E’s framework.

• The (EBT/EBIT) represents the financial expenses which, under the regression coefficients, are more relevant than debt, and in average represent 14.08% of EBIT according to the descriptive statistics in Table 1.
• And finally the tax effect ratio shows the impact of taxation on the return on equity.
• As can be seen below, the 5-steps of the DuPont method cross multiply into the return on equity formula.
• Investors can price this in by adjusting the interest burden rate by the expected increase in the company’s borrowing cost.

What is the 3 point DuPont analysis?

Analyzing a company’s return on equity through the DuPont method can give investors insights into how the company will be affected by changing economic, government tax policy, or financial market conditions. The Extended DuPont method further breaks down the already impressive 3-step standard DuPont model by considering how operating income, taxes, and interest expenses come together to form the company’s net income. Now that we have broken down the drivers of net profit margin extended dupont equation into 3 separate ratios, we can lay out the new 5-step Extended DuPont formula.

Total asset turnover ratio

Total asset turnover ratio is an asset-utilization ratio which measures how efficiently the company is using its total assets to generate revenue. It’s a very positive sign for a company if its ROE goes up due to an increase in the net profit margin or asset turnover. It makes things riskier, however, if the equity multiplier is the source of the rise and the company was already appropriately leveraged. The stock might deserve more of a discount despite the rise in ROE if the company is getting over-leveraged. It could be positive and show that the company is managing itself better if the company is under-leveraged.

As always with financial statement ratios, they should be examined against the company’s history and its competitors. Even if a company’s ROE has remained unchanged, examination in this way can be very helpful. Examination with DuPont analysis could show that both net profit margin and asset turnover decreased, two negative signs for the company, and the only reason ROE stayed the same was a large increase in leverage. All of the financial metrics in the Extended DuPont equation are key to a company’s profitability and are measured within the IFB Equity Model. Each of these metrics can be tracked and forecasted when doing a company valuation to understand where profits are being created. The IFB Equity Model is one of the courses and spreadsheets available on the IFB products page and allows users to easily value a company.

This approach is particularly useful for companies with complex business models or multiple product lines. In order to achieve a high ROE, a company must reduce its interest expense such that the EBT/EBIT ratio is high. But with some rearranging of the terms, we arrive at the three standard ratios mentioned earlier. If we multiply the ROE formula above by two ratios – “Revenue ÷ Revenue” and “Average Total Assets ÷ Average Total Assets” – we are essentially multiplying the ROE by one, since the numerator and denominator are the same in both ratios.

The first component on the right-hand side of the above equation is the tax burden. All three of these new parts are extensions of the net profit margin calculation. There are two additional components in the 5-step equation as compared to the 3-step equation. The starting point to arrive at these three components is the return on equity (ROE) formula. The default numbers in Valuation Tutor screens have (CO) after them to indicate that this is in relation to Continuing Operations.

With interest rates doubling in 2022 compared to the last couple of years, companies are going to see their costs of financing rise. Investors can price this in by adjusting the interest burden rate by the expected increase in the company’s borrowing cost. The weighted average maturity of a company’s debt outstanding which will need reissuance as well as the mix of floating versus fixed interest rate debt should be available in their financial statements and annual reports. The Extended version of the DuPont analysis further breaks down the profit margin by including tax rates and interest expenses separately. These new additions mean the Extended DuPont Analysis has five steps involved in its calculation instead of the standard three steps. Financial leverage is measured by the equity multiplier, which is calculated as average total assets divided by average shareholders’ equity.

Accounting Ratios

So for example you can see that the Net Earnings from Continuing Operations after tax is $10,946 and the Total Assets are $128,172 and so on. That is, the fifth term is again related to the financing decision; a highly leveraged firm has low Shareholders Equity compared to Assets.

Each of these components plays a crucial role in determining a company’s overall ROE. In the next part of our modeling exercise, we’ll calculate the ROE under the 5-step approach. Next, we’ll move on to the balance sheet assumptions, for which we only require two data points, the “Average Total Assets” and “Average Shareholders’ Equity” accounts. For convenience we again relate the numbers in the 10-K to the summary grid as depicted below and then refer to the line numbers in the summary grid.

Concept 50: DuPont Analysis

It’s generally a good sign for the company if this number goes up because it shows that the rate of return on the shareholders’ equity is rising. The problem is that this number can also increase simply when the company takes on more debt, thereby decreasing shareholder equity. This would increase the company’s leverage which could be a good thing but it will also make the stock riskier. Finally, the regression to be tested took Jin (2017)’s methodology as a theoretical reference (Damodaran, 2007; Weidman et al., 2019). Although Jin (2017) considered the dependent variable one period in the future from the rest of independent variables for its regression, the paper measured market effects, which sustain the need of the study to capture a later effect on the market. The current study focuses on the elements of the proposed FROE, all of which occur simultaneously, are extracted from the same data sources, and do not involve market information (Lukic, 2015).

This is a reminder to always double-check the data before using it in a DuPont analysis. Different accounting practices between companies can make accurate comparisons even more challenging. This can lead to inconsistent results, making it harder to draw meaningful conclusions.