DuPont Method Analysis
The DuPont analysis is a method of evaluating the effect of three components of the return on equity (ROE) on a single equation. It allows a financial analyst to assess the effect of the net profit margin, total asset turnover, and capital formation on ROE (Weil, Schipper, & Francis, 2014).
Gadge, Deora, & Katsure (2013) explain that it is a way of decomposing ROE into its three components. The three parts include profit margin, asset turnover, and financial leverage.
(Net income/ net sales) x (net sales/ total assets) = return on investment (ROI) (Weil et al., 2014).
ROI x financial leverage = ROE
Financial leverage = total assets/ stockholders’ equity (Thorp, 2012).
ROE = (net income/ net sales) x (net sales/ total assets) x (total assets/ total equity) (Gadge et al., 2013).
Profits
In the DuPont analysis, ROE is the focus of financial analysts because it is the main interest of shareholders. It shows the rate at which their wealth is increasing. Gadge et al. (2013) discuss that the firm’s primary goal is to make profits for its shareholders.
When a firm’s ROE rises, it increases the ability of the firm to generate additional profits. The ability increases without raising additional capital from shareholders and the financial market (Thorp, 2012).
The asset turnover ratio indicates how successful the firm has been in utilizing assets to generate sales (Weil et al., 2014). A firm should be able to increase sales when it increases assets.
A firm improving its efficiency is expected to increase sales using the same level of assets. Gadge et al. (2013) explain that asset turnover measures operating efficiency.
The profit margin shows the firm’s ability to control expenses and the cost of other inputs. Weil et al. (2014) suggest that it shows the effectiveness of the firm in controlling expenses relative to sales. A firm will increase its profit margin if it can reduce its expenses relative to sales. It can also increase its revenue relative to expenses.
Thorp (2012) explains that there are industries with a low profit margin because of intense rivalry among firms. Other industries have a high profit margin because a few firms are able to charge a premium price for their products.
However, the main purpose of the DuPont analysis is to assess the improvement of the profit margin component in increasing the ROE.
Financial leverage shows the combination of the sources of capital that the firm uses to generate income for shareholders. Shareholders will be satisfied when the size of their equity increases without providing additional capital.
Thorp (2012) explains that there is a share dilution when a firm decides to issue more shares to raise additional capital. Additional capital increases ability to generate revenues. Raising capital from debts reduces the net income through interest expense.
The more a firm borrows, the higher the interest rate it will be charged. Risk increases with more financial leverage (Thorp, 2012).
Outcomes
Thorp (2012) suggests that the DuPont analysis is a good model for evaluating a firm performance. However, it fails to capture the details in the performance of a firm. The signals found in the DuPont analysis should be investigated further to obtain the root cause of problems.
Thorp (2012) discusses a DuPont analysis made up of five components. In addition to the three parts, it assesses the interest burden on borrowed capital and tax efficiency.
The DuPont analysis can be used effectively to predict future changes in stock prices. Soliman (2008) conducted a survey that shows that positive changes in the DuPont components were followed by similar changes in the stock prices.
Soliman (2008) found out that a positive change in the asset turnover ratio predicted higher profitability in the future, after controlling for changes in the ROE. According to Soliman (2008), financial analysts may fail to predict future stock prices by failing to evaluate all components of the DuPont analysis.
The high frequency of prediction errors could be a sign that some analysts have failed to use all components of the DuPont analysis to make predictions (Soliman, 2008).
ROE Case Study
In the year 2007, the average firm in the S&P 500 Index had a total market value of five times stockholders’ equity (book value). Assume a firm had total assets of $10 million, total debt of $6 million, and net income of $600,000. What is the percent return on equity?
ROI = profit margin x total asset turnover
ROI = (net income/ net sales) x (net sales /total assets)
= $600,000/ net sales x net sales/ $10,000,000 = $600,000/ $10,000,000 = 6%
As shown above, net sales will cancel out because it is the same value, leaving the ROI as 6%.
ROE = ROI x financial leverage
ROE = 6% x ($10,000,000/ $ (10,000,000 – 6,000,000)
ROE = 6% x 2.5 = 15%
Return on Total Market Value
Book value = stockholders’ equity = total assets – total debts = $10,000,000 – $6,000,000 = $4,000,000
Total market value on average is five times book value = 5 x $4,000,000 = $20,000,000
Return on total market value = $600,000/ $20,000,000 = 3%
The return on the market (3%) appears inadequate because it is closer to the coupon rate of a thirty-year bond in the U.S. (Board of Governors of the Federal Reserve System, 2015). The 2.57% rate may be considered the risk-free rate. The stock market has a lot of risk. A higher premium should be generated to cover the risk.
Implications
As a shareholder, one can sell the shares and invest in other financial assets that generate higher returns. Shareholders can also put pressure on the managers to increase their operating efficiency.
References
Board of Governors of the Federal Reserve System. (2015). Selected interest rates (weekly) H.15. Web.
Gadge, A., Deora, B., & Kasture, R. (2013). Certified credit research analyst (CCRA) Level 1. New Delhi: Taxmann Publications.
Soliman, M. (2008). The use of DuPont analysis by market participants. The Accounting Review, 83(3), 823-853. Web.
Thorp, W. (2012). Deconstructing ROE: DuPont analysis. Web.
Weil, R., Schipper, K., & Francis, J. (2014). Financial accounting: An introduction to concepts, methods, and uses (12 ed.). Mason, OH: South-Western Cengage Learning.