The DuPont analysis, also called the DuPont identity, DuPont equation, DuPont framework, DuPont model, or the DuPont method, is an expression that divides ROE (return on equity) into three parts.
The name comes from the fact that this formula was first used by the DuPont company in the 1920s. In 1912, Donaldson Brown, a salesman for DuPont explosives, came up with the formula in an internal efficiency report.
Profitability: measured by profit margin
Asset efficiency: measured by asset turnover
Financial leverage: measured by equity multiplier
- ROE = (Profit margin)×(Asset turnover)×(Equity multiplier) = Net profit/Sales×Sales/Average Total Assets×Average Total Assets/Average Equity = Net Profit/Equity
- ROE = Profit/Sales×Sales/Assets = Profit/Assets×Assets/Equity
- ROE = ROS×AT = ROA×Leverage
The returns that investors obtain for every dollar of stock are broken down into three different components by the DuPont analysis. By comparing companies in related industries, this analysis enables the analyst to comprehend the cause of a superior (or inferior) return (or between industries).
For sectors like investment banking when the fundamental components are meaningless, the DuPont analysis is less helpful. For industries where the elements have a tenuous significance, different versions of the DuPont analysis have been devised.
Instead than increasing sales, some companies, like the fashion industry, may obtain a significant percentage of their competitive edge by selling at a larger margin. It may be crucial for high-end fashion firms to grow their sales without reducing their profit. Analysts can identify which element dominates any change in ROE using the DuPont analysis.
Industry With a High Turnover
Certain retail business models, especially shops, may have extremely low leverage and very poor profit margins on sales. However, grocery stores may experience extremely high turnover, selling a sizable portion of their assets each year.
Asset turnover may be closely examined for indications of under- or over-performance because the ROE of such enterprises may be particularly dependent on the performance of this indicator.
For instance, same-store sales of many retailers are crucial as a sign that the company is making more money from its current outlets (rather than showing improved performance by continually opening stores).
Some industries, like the banking sector, rely heavily on leverage to produce respectable ROE. High amounts of leverage would be considered unacceptably dangerous in other businesses. Third parties who primarily rely on their financial statements can compare leverage between similar companies thanks to DuPont analysis.
ROA and ROE Ratio
Many businesses now assess how well assets are used using the return on assets (ROA) ratio that DuPont created for its own usage. It calculates the effects of asset turnover and profit margins taken together.
The return on equity (ROE) ratio, which measures the rate of return to stockholders, is known as the DuPont system because it breaks down the ROE into different variables that affect firm performance.
- Net Income = net income after taxes
- Equity = shareholders’ equity
- EBIT = Earnings before interest and taxes
- Pretax Income is often reported as Earnings Before Taxes or EBT
Various ratios utilised in basic analysis are included in this decomposition.
- (Net income – Pretax profit) represents the tax burden on the business. After paying income taxes, this is the portion of the company’s profits that was kept. [NI/EBT]
- (Pretax income minus EBIT) represents the company’s interest expense. For a company with no debt or financial leverage, this will be 1.00. [EBT/EBIT]
- EBIT Revenue equals the company’s operating income margin, also known as return on sales (ROS). This represents operating income as a percentage of sales. [EBIT/Revenue]
- Asset turnover (ATO) for the business is calculated as (Revenue Average Total Assets).
- (Average Total Assets Average Total Equity) is the company’s equity multiplier. This quantifies financial leverage.