‘Quality without results is pointless. Results without quality is boring.’- Johan Cruyff, soccer player
Just like in all spheres of society, where quality is preferred, investors in equity markets seek quality stocks at reasonable prices.
Quality in case of stocks, is the comparison of the returns derived relative to the capital invested in stocks. The motive is understandable.
Investors attempt to protect their capital first and subsequently realize profit. While there are several ratios available to benchmark the financial performance of stocks, one powerful tool is the Dupont Analysis.
Dupont Analysis, also referred to as Return on Equity (ROE) is a measure of the profits generated in comparison to the amount of capital invested by a shareholder.
Before we delve into the technical aspects of Dupont analysis, the formula and the computation, let us learn about its origin.
Donaldson Brown of Dupont Corporation is credited with developing the DuPont analysis in the 1920s.
However, the motive was not towards analyzing stocks. Rather, Brown created the model to analyze the efficiency level of management in his company.
He minutely worked out a formula for return on equity with its various components. Overtime, owing to the accuracy of the formula, it was adopted by equity shareholders to analyze stock performance.
Why Is DuPont Analysis Important
The main advantage of the DuPont Formula is that it breaks up the ROE into subcomponents for better analysis of the financial performance by focussing on key strengths and weaknesses.
The three financial parameters that are broadly covered include:
1. Profits as a measure of efficiency of business operations. This is represented by the net profit margin.
Net Profit Margin = Net Profit/ Revenue from operations
2. Asset utilization levels as a measure of revenue generated from the asset base. In other words, it measures how efficiently and effectively the assets are used for business operations.
This is a critical component especially in manufacturing concerns, where a low capacity utilization or idle assets is a concern area. This is represented by the asset turnover ratio.
Asset Turnover= Revenue/ Total Assets
3.Financial Leverage as computed by the equity multiplier.
Equity Multiplier= Total Assets/Shareholder’s Equity
Combining the three parts, the ROE is worked out as follows
ROE= (Net Profit/Revenue)* (Revenue/Total Assets)* (Total Assets/Equity)
One must take care to use the above detailed formula with separate components to compute ROE rather than the simplified (Net Income/Equity). This is because, one can obtain a thorough analysis, with details of which component has contributed significantly towards the company’s ROE.
This would help grasp details about the viability of the business model, the sustainability of the revenue streams, the key performance drivers, the long-term strategy to be adopted for improvement of financial metrics and concern areas.
In case of a poor ROE, one can focus on the non-performing areas and take proactive, corrective measures.
Shareholders Rule the Roost!
Ultimately, shareholders are concerned about the wealth generation from utilization of business assets and conduct of business operations.
In other words, wealth creation is the bottom-line achieved or the net profits earned after deduction of business expenditure. This, as a comparison with the equity capital providing an accurate estimate of the ROE. It must be remembered that equity shareholders are the ultimate owners of the company and the goal of every business enterprise is to create shareholder value.
Let’s consider an example for better understanding of the DuPont Model.
Consider two companies X & Y each with an ROE of 20%, operating in the same industry. On further investigation, the breakup is as follows:
RoE = (Net profit margin) * (Asset turnover) * (Equity multiplier)
For Company X: RoE (X) = 20% * 0.2* 5=20%
For Company Y: RoE (Y) = 15% * 1.1* 1.2=20%
|Net Profit Margin||Asset Turnover||Equity Multiplier|
Inspite of the same overall ROE, the performance of the individual component ratios are very different.
The ROE of Company X is attributable largely to its healthy net profit margin of 20% and high financial leverage of 5x times. While high net profits are highly desirable and indicative of good financial performance, a high financial leverage is not optimal.
It is best to have a low equity multiplier, which means that a company requires low debt or borrowings to fund its asset base.
For example, suppose company X has total assets worth of Rs 200 crore and stockholders’ equity of Rs 40 crore. Its equity multiplier is 5(Rs 200 crore ÷ Rs 40 crore). The asset funding mix is as follows:
Equity to finance assets= 40/200= 20%
Debt to finance assets= (200-40)/200=160/200= 80%
This is actually a very risky situation, wherein the company is overleveraged or assumed excess debt. In case of a fall in profits, the company X could land into liquidity crisis or in a worse case scenario, become insolvent, being unable to repay debt. This would go against the fundamental going concern assumption!
In case of the profits taking a hit and the company X landing in a situation of defaulting on payments to creditors, the borrowers would take over the assets to recover the amounts. In such a situation of limited ownership of business assets, the company may lose valuable assets to debtholders and might ultimately have to shut shop!
Company Y, on the other hand, is able to generate moderate profits with sustainable levels of financial leverage of 1.2x times.
Key Questions to Ask
As one can see for the above examples, DuPont analysis raises vital questions like:
- Are the high profits of company X sustainable in the long run? Is the high net profit margin owing to better pricing power or decline in cost? If it is because of a decline in costs, whether the reduction is a temporary phenomenon due to the business cycle? Whether the company X enjoys better pricing due to gradually becoming an industry monopoly? Whether the company X enjoys a first mover advantage or brand equity?
- Why is company X overleveraged?
- Why is the asset turnover of company X negligible? Is it attributable to higher inventory holding or inadequate capacity utilization of the production facility?
- How is company Y able to effectively utilize its asset base?
Thus, the DuPont analysis provides valuable findings into the business operations, strategy, revenue model, balance sheet strength and profitability metrics of the company, which is not clear if one was to consider the ROE of 20% on a standalone basis.
One can also compare the change in ROE overtime and benchmark the performance with industry peers. This would help identify the good performers and the outliers in each sector.
It is prudent to include DuPont Analysis in your portfolio evaluation tools. Besides studying the financial statements, it makes sense to also study the individual components of the DuPont formula that provide valuable insights on business performance and risks.
This would help taking a decision as to whether one must hold on, sell or buy a stock based on its intrinsic worth as well as comparison to industry peers.
One must always remember to adopt a consolidated approach in stock picking rather than a standalone, narrow view of merely quarterly or annual declared results.
The DuPont analysis as a ratio measure is a powerful tool, when it comes to evaluation of diverse financial parameters, risk factors and business performance of a company’s stock.
Disclaimer: The views expressed in this post are that of the author and not those of Groww
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