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Dupont Analysis: Everything a stock investor should know

01 Oct 2022 0 COMMENT

When evaluating a company’s performance, the two most important metrics are the return on equity (ROE) and return on assets (ROA). The general formula of ROE is

ROE = Net income/Equity capital

The DuPont corporations introduced this method in 1920 to study the ROE by breaking it down into different components that provide different figures. DuPont formula is also known as the extended ROE formula. As per this formula, ROE can be written as

ROE = Net profit margin x Asset turnover x Financial leverage

Or ROE = (Net income/Sales) x (Sales/ Total assets) x (Total assets/ Equity capital)

Components of DuPont analysis

The company’s ROE is broken down into three components in this analysis.

1. Net profit margin

The net profit margin is one of the profitability ratio. It shows the net profit margin after deducting all relevant business expenses. This helps the company to cut unnecessary expenses and make price adjustments to get better profit margin.

Consider the case of company Y, which has an annual net profit of Rs 2,000 crore and yearly revenue of Rs 20,000 crore. The net profit margin, in this case, will be:

= (Net Profit ÷ Total Revenue) × 100

= (2,000 crore ÷ 20,000 crore) × 100

= 10%

2. Total asset turnover

This ratio defines if the company is using its assets effectively or not. For example, if a manufacturing firm has a large number of plants or machinery, its assets turnover ratio will be low, resulting in a decrease in ROE. To offset the impact of low asset turnover, the company needs to improve their profit margin. Furthermore, this ratio varies from industry to industry. Moreover, this ratio is best applied to businesses with sufficient tangible assets.

Assume that company Y’s total annual revenue is Rs 20,000 crore and its average assets are worth Rs 1000 crore. In this case, the asset turnover ratio will be.

= Revenue ÷ Average Assets

= 20000 crore ÷ 1000 crore

= 20

3. Financial leverage

This ratio emphasises the amount of debt used by the company to acquire assets and manage operational expenses. If a company uses excessive debt to cover business expenses, the interest outgo will be higher, resulting in a drop in the ROE.

Suppose company Y has Rs 1000 crore in average assets and Rs 500 crore in equity. In this instance, the financial leverage will be

= Average Asset ÷ Average Equity

= 1000 crore ÷ 500 crore

= 2

Relevance of DuPont analysis

Many investors consider only the company’s ROE when making a stock investment decision. But does the ROE accurately reflect financial health? Maybe not. Consider the following two companies: X and Y. Both of them are in the same industry and have an improvement in their ROE from 30% to 45%.

According to the DuPont analysis, the company’s actual financial position is as follows.

Parameters

Company X

Company Y

Year 1

Year 2

Year 1

Year 2

Profit margin

10%

15%

10%

10%

Asset turnover ratio

1.5

2

2

2

Financial leverage 

2

1.5

1.5

2.25

ROE

30%

45%

30%

45%

The table above shows that company X is successfully managing its production costs, allowing it to generate a higher profit margin.  It is also able to utilise its assets better and able to reduce its financial leverage by reducing the debt component.

On the other hand, company Y has the same profit margin and asset utilisation but increased its debt component to increase ROE. However, a higher debt component is considered risky and it may impact profitability of company Y.

Thus, if you are an investor, you can consider choosing Company X because it has a better profit margin and less debt.

Interpretation of DuPont analysis

DuPont analysis provides a clear picture of the company’s financial health. This analysis can be used to understand the strengths and weaknesses of any company. For example, if you want to invest in a company with a high ROE, you should first determine whether the high ROE is due to, excessive financial leverage, or a high-profit margin.

Benefits of DuPont analysis

  • DuPont analysis can assist you in understanding the reasons for a company’s healthy performance and growth.
  • In DuPont analysis, the three components of ROE provide detailed information about the company’s financial health. You can use this analysis to determine whether the higher ROE is due to better profit margin, asset utilisation or higher leverage.

Drawbacks of DuPont analysis

  • DuPont analysis is performed after obtaining data from any company’s financial records. However, the numbers will not provide an accurate interpretation if the company’s financial reporting practices are unethical.
  • Different industries face different types of situations. And these factors significantly impact financial ratios, sometimes providing an ambiguous prediction of the company’s performance.

To conclude

The DuPont analysis facilitates a detailed comparison of two companies in the same industry. It can assist you in determining a company’s strengths and weaknesses. Using this method, you can analyse the reason for a high or low ROE.

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