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Demystifying RoEs through DuPont Analysis

Apr 10, 2012

In this first article of a series, we introduce the DuPont method as a key technique for analyzing the performance of companies to invest in.

Are you in the dark regarding your investments?

What do you look for in a company before investing in it? Industry prospects. Management credentials. Information about its products. Market share and competitors. Profit margins and financial ratios. Right?

Most of us work through such a checklist of criteria to pick stocks to invest in. This systematic scrutiny gives us a satisfying feeling that we have thoroughly researched these companies.

Is this sufficient evidence to commit you to a investing in a stock? We believe not.

There may still be some loopholes which might have been overlooked.

Shedding light through the DuPont Method

In this is the first article of this series, we introduce the concept of the DuPont method and its value when applied.

The DuPont method will enable you to unearth facts that are not so obvious, and so lead you to making more informed and better investment decisions.

The DuPont analysis was developed by DuPont Corporation in the 1920s. It is a performance measurement technique to better understand Return on Equity (ROE). RoE is an important ratio that tells us how much wealth a company can potentially generate for its shareholders.

This DuPont analysis examines RoE (Net Profit/Equity) through three components which are:

  • Operating efficiency, measured by profit margin (Net Profit/Sales)

  • Asset use efficiency, measured by total asset turnover (Sales/Total Assets)

  • Financial leverage, measured by the equity multiplier
Put in equation form,

RoE (Return on Equity) = (Net profit margin) * (Asset turnover) * (Equity multiplier) OR

RoE = Net Profit/ Equity = (Net Profit/ Sales) *(Sales/Total Assets) * (Total Assets/Equity)

Through our investigation of RoE using the DuPont method, we have the advantage of getting a detailed picture of which component has contributed the most (and the least) to the company's RoE. This in turn will tell us if the company has sound fundamentals, and if it can sustain its performance in the long run. The DuPont equation also allows the analyst to see the overall strategy and key drivers for a company. And, if a company's ROE is unsatisfactory, the DuPont analysis helps locate that part of the business that is underperforming.

DuPont Analysis - An Example

An hypothetical example aids us in grasping the value of the DuPont model. Consider two companies, company A and company B, each with a RoE of20%. Prima facie (or At first glance), they look like equally attractive investments. Now, we can delve deeper by using the DuPont analysis:

RoE = (Net profit margin) * (Asset turnover) * (Equity multiplier)

For Company A: RoE (A) = 31% * 0.1* 6.5

For Company B: RoE (B) = 16% * 1.0* 1.2

We observe that even though both the companies generate the same RoE, their inherent components are very different, and so communicate unique information regarding the company.

RoE of company A at 20% is mainly because of the high net profit margin (of 31%) and huge financial leverage (of 6.5) that the company has. While a high net profit margin is desirable, financial leverage should be optimum and not so high. For company B, even with a lower (lower than company A) net profit margin of 16%, it is able to generate an RoE of 20% as a result of its high asset turnover ratio which is fine.

While the DuPont method highlights key strategic aspects of the companies, it also raises important questions. For instance, why is Company A's profit margin so high? And is that sustainable? Also, why does Company A have so much debt on its books?

For Company B, an obvious question is "is its profit margin in line with that of the sector".

Clearly, the DuPont method, through what it highlights, and the questions it raises, provides insights into these company's strategies and operations, in a way that is not evident from just knowing their 20% RoE. This is the power of this analysis.

From Concept to Application - BSE 500

We introduced the idea of the DuPont analysis of RoE through its three components, and highlighted the importance of this technique because of the rich information it extracts.

In our next article we dig through the BSE 500 universe of companies using Du Pont method, and examine what this analysis unveils regarding these companies from an investment perspective.

Essentially, we will learn which RoE component has been instrumental in enabling the company to earn rich returns for its equity shareholders? And is this sustainable? Also, why the companies that have destroyed wealth, have done so.

This knowledge will shed sharp light on which companies to invest in.

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3 Responses to "Demystifying RoEs through DuPont Analysis"

Shashi

Apr 21, 2012

Please try to be more simplistic while explaining the above examples, So that a lay investor can understand easily.
Regards.

Like 

Lakshmikanth Rao

Apr 10, 2012

Good One...More eager to read the next article on this..

Like 

Jagannath D

Apr 10, 2012

Thanks for the article .This is a good one.

Like 
  
Equitymaster requests your view! Post a comment on "Demystifying RoEs through DuPont Analysis". Click here!

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