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The DuPont analysis is a modification on calculating return on equity (ROE), but it uses a gross
value for assets, where accumulated depreciation is ignored. The DuPont analysis method
renders a higher ROE. The DuPont Corporation developed this analysis tool in the 1920s.
The formula is:
ROE = Profit Margin x Asset Turnover x Equity Multiplier
Profit Margin measures operating efficiency. Asset Turnover measures asset use efficiency
how well did the managers use the assets to generate sales? Finally, the Equity Multiplier
measures the amount of financial leverage used by the company.
The theory behind using gross asset value instead of net asset value is that it encourages
managers to get the most out of the assets. If net asset values are used, ROE is lower because
of accumulated depreciation. To make it higher, managers invest in new equipment to make
the assets accounts higher.
Basic ROE analysis may provide a misleading ROE. The three-step analysis of ROE used in the
DuPont method allows an investor to determine the reason the total ROE number changed. For
instance, if the profit margin or asset turnover portions of the ROE increase, then that is a sign
of good company management. However, if ROE goes up because the company borrowed more
money, thus using a greater amount of financial leverage, this might indicate that the
company is a risky investment.
Three-Step DuPont
To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In
the 1920s the DuPont corporation created an analysis method that fills this need by
breaking down ROE into a more complex equation. DuPont analysis shows the
causes of shifts in the number.
There are two variants of DuPont analysis: the original three-step equation, and an
extended five-step equation. The three-step equation breaks up ROE into three
very important components:
ROE = (net profit margin) * (asset turnover) * (equity multiplier)
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). The usefulness should now be clearer.
If a company's ROE goes up due to an increase in the net profit margin or asset
turnover, this is a very positive sign for the company. However, if the equity
multiplier is the source of the rise, and the company was already appropriately
leveraged, this is simply making things more risky. If the company is getting over-
leveraged, the stock might deserve more of a discount despite the rise in ROE. The
company could be under-leveraged as well. In this case it could be positive and
show that the company is managing itself better.
Even if a company's ROE has remained unchanged, examination in this way can be
very helpful. Suppose a company releases numbers and ROE is unchanged.
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. No matter what the initial
situation of the company, this would be a bad sign.
Five-Step DuPont
The five-step, or extended, DuPont equation breaks down net profit margin
further. From the three-step equation we saw that, in general, rises in the net
profit margin, asset turnover and leverage will increase ROE. The five-step
equation shows that increases in leverage don't always indicate an increase in ROE.
If the company has a high borrowing cost, its interest expenses on more debt could
mute the positive effects of the leverage.