The DuPont Analysis- a simple approach

  The reason I am going to discuss the DuPont analysis is two folds:

 1. First I think it is very useful to understanding, as well as explaining, changes in ROE. This is a measure that almost every executive considers; it also helps managers gauge their own performance from a profit/loss perspective to identify where resources are being wasted.

2. Secondly it is a subject that pops up a lot in interviews, “What do you know about the DuPont Equation?”, “If I ask you today to measure the ROE how would you go about it?”, and so on. Here I would like to note that two other topics that are liked by interviewers are the Enterprise Value Added (EVA) and the Free Cash Flow (FCF) but we can tackle these later on.

There are two common variants of the DuPont analysis (in the field the DuPont Equation can come in many variants but we will only deal with two): The three step model and the five step model (remember ‘three’ and ‘five’ that way it will be easy to check and confirm if you have all the formula components):

Three Step DuPont Analysis

ROE = NI / Equity = (NI / Sales) * (Sales / Assets) * (Assets / Equity)

I advice you use the following logic to remember the formula:

1.     I am looking for the Return on Equity (ROE).

2.     ‘Return’ means Net Income (NI), and ‘on Equity’ means divided by Equity (on = on top) thus ROE = NI / Equity (fact 3 from “How to deal with those Financial Ratios?”).

3.      Memorize that the DuPont Equation starts with the Net Income Margin (NI / Sales).

4.     We have (NI / Sales) and we aim to get to (NI / Equity), we want a formula to delete the sales. That formula happens to be one of the most common ratios used to analyze assets performance,

          i.e. the assets turnover ratio (Sales / Assets).

5.     Now we have: (NI/ Sales) * (Sales / Assets) = (NI / Assets)…but I want (NI / Equity) so I also need an equation that will delete the Assets and replace it with Equity.

6.     That equation is the Equity Multiplier which is (Assets / Equity). In which (NI / Assets) * (Assets / Equity) = NI / Equity.

Ok so now we know what the equation is, but how do we use it, and why do we use it?

Assume you have a company for which you have done the following calculations:

DuPont ModelCompany A
	2004	2005	2006
Net Income Margin	7%	8%	7%
Assets Turnover ratio	1.56	1.81	1.76
Equity Multiplier	1.37	1.68	1.99
ROE	15.79%	23.65%	25.32%

We know that the ROE has improved, which is a good thing, but my value added (as an information filter for my boss) lies in the fact that I provide an answer to the question “why has the ROE improved”?

Looking at the components of the DuPont Model:

• NI Margin:  Has increased between 2004 and 2005 thus the management is able to generate more NI from the sales; management has become more efficient. Increasing NI Margin means higher operational efficiency.
• Assets Turnover ratio: Has increased between 2004 and 2005 thus management is generating more sales from the assets base they have; asset utilization has improved. Increasing Assets Turnover means a more efficient use of the assets.
• Equity Multiplier: Has increased between 2004 and 2005. The Equity Multiplier measures how much of the total capital the firm has is from equity. To refresh your memory, total capital is another word for total assets and money for assets (the things a company buys) comes from two sources Debt and Equity, here (the term is Equity Multiplier) we care about Equity. Thus the Equity Multiplier is comparing the assets against the equity. Since the ratio is increasing it means that the firm’s assets are rising faster than its equity and thus the firm is using more and more debt (leverage), which is not always a good thing. The Higher the Equity Multiplier the more leverage management uses.

Conclusion (2004-2005): The improvement in the ROE between 2004 & 2005 was due to management generating more sales from the assets, and increasing the amount of NI they retain from the sales generated. As signified by the improved assets turn over and NI margin. This was possible however by an increase in leverage.

Conclusion (2005-2006): ROE improvement was the result of using more debt, as signified by the increase in the Equity Multiplier. However the falling NI margin and the falling assets turnover indicate a fall in efficiency. Note: The strength of the Du Pont model is clear in this example: Although we have an improved ROE between 2005 & 2006, it is not due to better management performance; rather due to higher leverage. For another example, by Max Saffell and Samuel Toba, please check the following link:  http://boilthisdown.org/wp-content/uploads/2010/02/Using-DuPont-to-look-at-DuPont.pdf

Five Step DuPont Analysis

ROE = NI / Equity = [(EBIT/ Sales) * (Sales / Assets) – (Int Expense / Assets)] * (Assets / Equity) * (1 – Tax Rate)

The five step model is simply an expansion of the initial three step model. It involves segregating the Net Income, from the three step model, into Operating income (EBIT), less interest expense, fewer taxes : Net Income = (EBIT – Interest Expense) * (1 – Tax rate)

So how can one easily memorize this five step model?

We already know the three step model, and we know that the five step model is simply an expansion of that, so let us start by writing the three step model:

ROE = NI / Equity = (NI / Sales) * (Sales / Assets) * (Assets / Equity)

Remember, the only change is that the NI is divided into its components:

1.     Start by putting the common elements that did not change:

ROE = [(XXX / Sales) * (Sales / Assets) – (XXX / XXX)] * (Assets / Equity) * (XXX)

2.     Now start replacing the XXX with the NI components

3.     The  NI is EBIT less interest expense and less taxes, so:

• plug-in the EBIT:

ROE = [(EBIT/Sales) * (Sales / Assets) – (XXX / XXX)] * (Assets / Equity) * (XXX)

• less interest expense:

ROE = [(EBIT/Sales) * (Sales / Assets) – (Int Expense / Assets)] * (Assets / Equity) * (XXX)

• less taxes:

ROE = [(EBIT/Sales) * (Sales / Assets) – (Int Expense / Assets)] * (Assets / Equity) * (1 – Tax Rate)

Some notes:

1. The reason we plug-in the EBIT is because on the Income Statement the level of profit above the NI is the operating income.
2. We divide the Interest Expense by the Assets in order to have a common denominator with the EBIT from which we are subtracting the interest expense.
3. Multiplying by (1 – tax rate) will give you the income after taxes, which is the NI. It is perfectly correct to subtract the tax expense from the income before taxes but that would complicate things as you need a common denominator. Sometimes you might be analyzing a company where you have the NI and the Tax expense (which are typical components of any Income statement) and you need to calculate a tax rate, careful the tax rate is not the tax expense divide by the NI. This is because the NI is the income after taxes; the tax rate is actually the Tax Expense divided by the (NI + Tax Expense). The (NI + Tax Expense) is the before tax income, on which the tax rate is applied.

The reason we expand the three steps DuPont into the five steps form, is to drill the details. For example you might have a situation where the ROE is growing due to a continuous year-on-year growth in the net income, without much of a change in the assets turnover and the equity multiplier.  The expanded form will give insight into the reasons for the NI growth.