Dupont Analysis: Everything a Stock Investor Should Know

What is Dupont Analysis

DuPont analysis is a kind of framework used to analyse the fundamental performance. It is majorly utilised for comparing the operational efficiency of two similar types of firms.

DuPont analysis is a helpful technique and strategy used for decomposing the different drivers of ROE.

Why Is DuPont Analysis Important

The main advantage of the Dupont Analysis Formula is that it breaks up the ROE into subcomponents for better analysis of the financial performance by focusing on key strengths and weaknesses.

The three financial parameters that are broadly covered include:

1. Profits as a measure of the 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 the 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 toward 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, and the long-term strategy to be adopted for the 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 generated from the utilization of business assets and the conduct of business operations.

In other words, wealth creation is the bottom-line achieved or the net profits earned after the deduction of business expenditure.

This, as a comparison with the equity capital, provides 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.

Example:

Let’s consider an example for a 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%

In spite 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, 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 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, company X could land into a liquidity crisis or in a worst-case scenario, become insolvent, being unable to repay debt. This would go against the fundamental going concern assumption!

In case of the profits take a hit and company X lands 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 from the above examples, Du Pont 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 a decline in cost? If it is because of a decline in costs, whether the reduction a temporary phenomenon due to the business cycle? Whether company X enjoys better pricing due to gradually becoming an industry monopoly? Whether 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 over time and benchmark the performance with industry peers. This would help identify the good performers and the outliers in each sector.

Final Thoughts

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 to make 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 is a ratio measure that is a powerful tool when it comes to the evaluation of diverse financial parameters, risk factors and business performance of a company’s stock.

Happy Investing!