Decoding DuPont Analysis

Return on equity (ROE) is a strong measure of how well a company’s management creates value for its shareholders. It’s a closely-watched number among knowledgeable investors but the number can be misleading.

ROE is vulnerable to measures that increase its value while also making the stock riskier. Investors could be duped into believing a company is a good investment when it’s not without a way of breaking down ROE components, DuPont analysis can break apart ROE and lead to a much better understanding of where movements in ROE are coming from.

Return on Equity (ROE)

The beauty of ROE is that it’s an important measure that requires only two numbers to compute: net income and shareholders’ equity.

$\beginaligned &\textROE = \frac \textNet Income \textShareholder Equity \\ \endaligned$​ROE=Shareholder EquityNet Income​​

It’s generally a good sign for the company if this number goes up because it shows that the rate of return on the shareholders’ equity is rising. The problem is that this number can also increase simply when the company takes on more debt, thereby decreasing shareholder equity. This would increase the company’s leverage which could be a good thing but it will also make the stock riskier.

Three-Step DuPont

A more in-depth knowledge of ROE is necessary to avoid mistaken assumptions. The DuPont corporation created an analysis method in the 1920s that fills this need. It breaks ROE down into a more complex equation. DuPont analysis shows the causes of shifts in the number.

The three-step equation breaks up ROE into three very important components:

$\beginaligned &\textROE = \textNPM \times \textAsset Turnover \times \textEquity Multiplier \\ &\textbfwhere: \\ &\textNPM = \textNet profit margin, the measure of operating \\ &\textefficiency \\ &\textAsset Turnover = \textMeasure of asset use efficiency \\ &\textEquity Multiplier = \textMeasure of financial leverage \\ \endaligned$​ROE=NPM×Asset Turnover×Equity Multiplierwhere:NPM=Net profit margin, the measure of operatingefficiencyAsset Turnover=Measure of asset use efficiencyEquity Multiplier=Measure of financial leverage​

The Three-Step DuPont Calculation

This is what we get when taking the ROE equation of ROE = net income/shareholder’s equity and multiplying the equation by (sales/sales):

$\beginaligned &\textROE = \frac \textNet Income \textSales \times \frac \textSales \textShareholders’ Equity \\ \endaligned$​ROE=SalesNet Income​×Shareholders’ EquitySales​​

We’ve now broken ROE down into two components. The first is the profit margin and the second is the equity turnover ratio. We end up with the three-step DuPont identity by multiplying in (assets/assets):

$\beginaligned &\textROE = \frac \textNet Income \textSales \times \frac \textSales \textAssets \times \frac \textAssets \textShareholders’ Equity \\ \endaligned$​ROE=SalesNet Income​×AssetsSales​×Shareholders’ EquityAssets​​

This equation for ROE breaks it into three widely used and studied components:

$\beginaligned &\textROE = \textNPM \times \textAsset Turnover \times \textEquity Multiplier \\ \endaligned$​ROE=NPM×Asset Turnover×Equity Multiplier​

We have ROE broken down into net profit margin or how much profit the company gets out of its revenues, asset turnover or how effectively the company makes use of its assets, and equity multiplier which is a measure of how much the company is leveraged. The usefulness should now be clearer.

It’s a very positive sign for a company if its ROE goes up due to an increase in the net profit margin or asset turnover. It makes things riskier, however, if the equity multiplier is the source of the rise and the company was already appropriately leveraged. The stock might deserve more of a discount despite the rise in ROE if the company is getting over-leveraged. It could be positive and show that the company is managing itself better if the company is under-leveraged.

Examination in this way can be very helpful even if a company’s ROE has remained unchanged. Suppose a company releases numbers and ROE is the same. Examination with DuPont analysis could show that both net profit margin and asset turnover decreased, two negative signs for the company. The only reason ROE stayed the same was a large increase in leverage. This would be a bad sign no matter what the initial situation of the company was.

Five-Step DuPont

The five-step or extended DuPont equation breaks down net profit margin further. The three-step equation told us that rises in the net profit margin, asset turnover, and leverage will generally increase ROE. The five-step equation shows that increases in leverage don’t always indicate an increase in ROE.

The Five-Step DuPont Calculation

The numerator of the net profit margin is net income so this can be made into earnings before taxes (EBT) by multiplying the three-step equation by one minus the company’s tax rate:

$\beginaligned &\textROE = \frac \textEBT \textS \times \frac \textS \textA \times \frac \textA \textE \times ( 1 – \textTR ) \\ &\textbfwhere: \\ &\textEBT = \textEarnings before tax \\ &\textS = \textSales \\ &\textA = \textAssets \\ &\textE = \textEquity \\ &\textTR = \textTax rate \\ \endaligned$​ROE=SEBT​×AS​×EA​×(1−TR)where:EBT=Earnings before taxS=SalesA=AssetsE=EquityTR=Tax rate​

We can break this down one more time because earnings before taxes are simply earnings before interest and taxes (EBIT) minus the company’s interest expense. We get this if there’s a substitution for the interest expense:

$\beginaligned &\textROE = \left ( \frac \textEBIT \textS \times \frac \textS \textA – \frac \textIE \textA \right ) \times \frac \textA \textE \times ( 1 – \textTR ) \\ &\textbfwhere: \\ &\textIE = \textInterest expense \\ \endaligned$​ROE=(SEBIT​×AS​−AIE​)×EA​×(1−TR)where:IE=Interest expense​

The practicality of this breakdown isn’t as clear as the three-step but this identity provides us with:

$\beginaligned &\textROE = ( \textOPM \times \textAT – \textIER ) \times \textEM \times \textTRR \\ &\textbfwhere: \\ &\textOPM = \textOperating profit margin \\ &\textAT = \textAsset turnover \\ &\textIER = \textInterest expense rate \\ &\textEM = \textEquity multiplier \\ &\textTRR = \textTax retention rate \\ \endaligned$​ROE=(OPM×AT−IER)×EM×TRRwhere:OPM=Operating profit marginAT=Asset turnoverIER=Interest expense rateEM=Equity multiplierTRR=Tax retention rate​

The company’s interest expenses on more debt could mute the positive effects of the leverage if it has a high borrowing cost.

Learn the Cause Behind the Effect

Both the three- and five-step equations provide a deeper understanding of a company’s ROE by examining what’s changing in a company rather than looking at one simple ratio. They should be examined against the company’s history and its competitors, as always with financial statement ratios.

One may have a lower ROE when looking at two peer companies. You can see with the five-step equation if it’s lower because creditors perceive the company as riskier and charge it higher interest, the company is poorly managed and has leverage that’s too low, or the company has higher costs that decrease its operating profit margin. Identifying sources like these leads to better knowledge of the company and how it should be valued.

The Bottom Line

A simple calculation of ROE may be easy and tell quite a bit but it doesn’t provide the whole picture. The three- or five-step identities can help show where the company is lagging if its ROE is lower than those of its peers. It can also shed light on how a company is lifting or propping up its ROE. DuPont analysis helps significantly broaden understanding of ROE.