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DuPont Analysis Definition
The DuPont analysis which is also called the DuPont model or the DuPont identity is a framework which is utilized in the analysis of fundamental performance that was made famous by the DuPont corporation. DuPont model is a very useful computational technique used in decomposing the different factors behind returns on equity (ROE). Returns on equity decomposition helps the investor to focus primarily in the crucial aspects of the financial performance of each individual part of his portfolio and also to identify the strengths and weaknesses of each of his investments.
Returns on equity (ROE) are fundamentally driven by three basic metrics: operating efficiency, asset use efficiency, and lastly; financial leverage. Operating efficiency is depicted by net profit margin or the net income per total sales or revenue generated. Asset use efficiency is measured specifically by the asset turnover ratio. Financial leverage is measured using the equity multiplier which is usually equivalent to the average assets per average equity.
A Little More on What is the DuPont Analysis
DuPont analysis or DuPont model or DuPont identity is an extensive return on equity formula, and it is computed by multiplying the net profit margin by the asset turnover and finally by the equity multiplier.
The Lessons from DuPont Analysis
A DuPont identity is used to analyze the different individual parts of a firm’s return on equity (ROE). Using this model, investors can determine which investment is generating the most income or the most percentage profit to the return on equity (ROE). Portfolio managers can make use of DuPont analysis in calculating and matching the operational efficiency of two similar companies. Also, they can make use of DuPont model in identifying the weaknesses and the strengths that needs to be checked in a portfolio.
Constituents of DuPont Analysis
In DuPont analysis, ROE is split into several parts to determine and decide which particular part or factor is actually responsible for the changes being felt in the ROE.
Net Profit Margin
Net profit margins refers to the ratio of bottom line profits compared to total revenue or total sales generated by a firm. The net profit margin is one of the primary measures of a firm’s profitability or gains. To put this concept into a realistic view, let us take a look at a small business being managed by a male vendor. Assume that John sells a unit of shampoo for $10.00. Now, since John is not a producer, and even if he was, since he doesn’t own the raw materials he’ll be using, then he must incur cost of production. Now, if the cost of production of a unit of shampoo is equivalent is $8 (raw materials, labor, taxes, etc.), then the profit which John would realize per shampoo sold would be equal to $2. Simply put, we can say that John’s profit margin is equivalent to 20% of the cost of a unit of his product. This can be calculated as;
Net Profit Margin = net income/revenue = $2/$10 = 20%.
John can however choose to increase his profit margin either by increasing the cost of goods and services or by reducing the cost of the factors of production. Either way, if any of these actions are taken, it would have a great effect on the returns on equity (ROE). In a more realistic market setting, we can see how volatility hits a stock when management makes a change to its strategy for future margins, costs of operations, and prices of goods and services.
Asset Turnover Ratio
Asset turnover ratio refers to how a company uses its assets efficiently to generate revenue or income. Let us take a look at John’s shampoo business above. Imagine that the total value of John’s assets were to be worth $1000, and he decides to make use of $300 in generating revenue. Now, if John is able to generate $3000 at the end of the year using that amount, we can say that he generated 10times value in total revenue, and this is same as the asset turnover ration which can be calculated as:
Asset Turnover Ratio = Assets Revenue / Average Assets = $3000/$300 = 10.
Assets turnover ratios can vary from one sector to another, as not all investments can yield as much as another. For clarity, let us assume that Mary is a retailer and she manages to sell a large amount of products in a day. With a high volume of sales, Mary’s assets turnover ratio can beat over 1000% in a month, because she is focused mostly on selling smaller units in larger quantities. However, it is important to note that her asset might not be worth more than $1000 before the turnover. On the other hand, if Samuel is the owner of a financial investment fund, and his company holds up to $10 billion in assets, then a 25% yearly asset turnover ratio would be considered amazing, even if the number of percentage is not up to that of Mary’s. So the trick here is that the larger the asset value, the lower the asset turnover ratio and vice-versa.
Asset turnover ratio can also be useful in comparing the performance of two companies that are alike. Since average assets include different individual parts like company inventory, changes in ratio can signal that sales volume is declining or increasing faster than in another firm. Typically a firm’s ROE is expected to increase if its asset turnover ratio increases.
Financial leverage in returns on equity refers to a passive examination of a firm’s use of debt to finance its assets or securities. For instance, if John has $3000 in assets and $600 in equity, the balance will depict the his business to be incurring $2400 in debts as equity is the difference between liabilities and assets. If John decided to borrow more money to fund his assets, the ratio will increment according to the degree of debt incurrence. Financial leverages are computed using balance sheets, and this allows analysts to divide average assets by average equity instead of the total balance at the end of the business season. Mathematically, financial leverage is calculated as:
Financial Leverage = Average Assets / Average Equity = $3000 / $600 = 5.
Most firms make use of financial leverage in making undertaking projects and investments as well as fund their business operations especially when accompanied with equity. The use of leverage helps a firm grow faster and match up with its competitors, as it’d have more money than it’d have actually possessed in carrying out a project. However, since leverage is a double-edge sword, it is important that businesses limit using them to a certain point, as too much debt can lead to failure.
Walmart (NYSE: WMT) has a net income of $5.2 billion over twelve months, revenue of $512 billion, assets of $227 billion, and shareholders equity of $72 billion. According to released data which is deemed accurate, the firm’s net profit margin is 1% or mathematically $5.2b/$512b. Its assets turnover is 2.3x which is gotten from computing $512b/$227b. Its financial leverage is 3.2x, which is $227b/$72b. Using this data, we can see that the return on equity of Walmart is 7.4% or 1% x 2.3 x 3.2.
DuPont Analysis and ROE: Differences
DuPont identity is an extended model of the return on equity of a firm, while the return on equity is the net income generated from the operation period divided by the shareholders equity. ROE calculation reveals the extent to which a company makes use of the capital from its shareholders. DuPont model on the other hand allows investors and security analysts to determine or understand what leads to changes in ROE, as well as why a return on equity is considered low or high. Simply put, DuPont analysis helps us to understand the factors that are behind the returns on equity of a company, whether it be profit maximization, assets use, and or leverage.
DuPont Identity: The Shortcomings
Like all things used in the finance world, the DuPont analysis has some limitations which it doesn’t seem to surpass. A major example of such shortcoming is its absolute reliance on manipulatable financial and accounting data. Apart from this, the DuPont model also has no base as to why returns on equity should be considered strong or weak, high or low, or over-performing and underperforming.