DUPONT ANALYSIS

I. RETURN ON EQUITY (ROE)

Return on equity (ROE) is a closely-watched number among knowledgeable investors. It is a strong
measure of how well a company's management creates value for its shareholders. The number can be
misleading, however, as it is vulnerable to measures that increase its value while also making the stock
riskier. Without a way of breaking down ROE components, investors could be duped into believing
a company is a good investment when it's not. Read on to learn how to use DuPont analysis to break
apart ROE and gain a much better understanding of where movements in ROE are coming from.

KEY TAKEAWAYS
 DuPont analysis is a framework for analyzing fundamental performance originally
popularized by the DuPont Corporation, now widely used to compare the
operational efficiency of two similar firms.
 DuPont analysis is a useful technique used to decompose the different drivers of
return on equity (ROE).
 There are two versions of DuPont analysis, one utilizing decomposing it into 3
steps and another 5 steps.

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

If this number goes up, it is generally a good sign for the company as it is showing 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.

II. THREE-STEP DUPONT

A more in-depth knowledge of ROE is necessary to avoid mistaken assumptions. In the 1920s, the
DuPont corporation created an analysis method that fills this need by breaking down ROE into a
more complex equation. DuPont analysis shows the causes of shifts in the number.
There are two variants of DuPont analysis: the original three-step equation, and an extended five-step
equation. The three-step equation breaks up ROE into three very important components:
The Three-Step DuPont Calculation
Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales
/ sales), we get:

We now have ROE broken into two components: the first is net profit margin and the second is the
equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont
identity:

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

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

If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a
very positive sign for the company. However, if the equity multiplier is the source of the rise, and the
company was already appropriately leveraged, this is simply making things riskier. If the company is
getting over-leveraged, the stock might deserve more of a discount despite the rise in ROE. The
company could be under-leveraged as well. In this case, it could be positive and show that the company
is managing itself better.

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

III. FIVE-STEP DUPONT

The five-step, or extended, DuPont equation breaks down net profit margin further. From the three-
step equation we saw that, in general, rises in the net profit margin, asset turnover and leverage will
increase ROE. The five-step equation shows that increases in leverage don't always indicate an increase
in ROE.

The Five-Step Calculation

Since the numerator of the net profit margin is net income, this can be made into earnings before
taxes (EBT) by multiplying the three-step equation by 1 minus the company's tax rate:

We can break this down one more time since earnings before taxes is simply earnings before interest
and taxes (EBIT) minus the company's interest expense. So, if there is a substitution for the interest
expense, we get:

The practicality of this breakdown is not as clear as the three-step, but this identity provides us with:
If the company has a high borrowing cost, its interest expenses on more debt could mute the positive
effects of the leverage.

IV. 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 is changing in a company rather than looking at one simple ratio. As always with
financial statement ratios, they should be examined against the company's history and its competitors.

For example, when looking at two peer companies, one may have a lower ROE. With the five-step
equation, you can see if this is lower because:
 creditors perceive the company as riskier and charge it higher interest, the company is poorly
managed and has leverage that is 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.

V. THE BOTTOM LINE

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