Breaking Down ROE: DuPont Analysis of Profit Margin, Asset Turnover, and Equity Multiplier, Lecture notes of Business Management and Analysis

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DuPont is a type of analysis that examines a company's Return on Equity (ROE) by breaking it into three main components: profit margin, asset turnover and leverage factor.

What is DuPont Analysis?

DuPont analysis enables one to determine what, if anything, is causing a change in its Return on Equity (ROE). This is accomplished by breaking these returns into three parts:

_1. Profit Margin

2. Asset Turnover
3. Return on Assets._

Breaking down the DuPont Analysis

We start with the return on equity (ROE). The formula for the ROE appears below: Now, we split the numerator from the denominator by multiplying both with total assets. By doing so, we have two ratios, the first is the return on assets (ROA) and the second is the equity multiplier. By breaking down the ROE into these two ratios, we can see how much of the reported ROE is due to the profitability of assets and how much to leverage. ROE = Profit for the Financial Year Equity ROE = Profit for the Financial Year X Total Assets Total Assets Equity The ROA shows the rate of profitability from the investment in total assets. Suppose two companies in the same industry have the same dollar amount of profit for the financial year. We would argue that the company with fewer assets had performed better. because the income was produced with fewer assets. We will shortly dissect the ROA even further Equity multiplier shows how debt usage can “lever up” the ROE. As leverage increases, the equity multiplier increases. For example, a company with a debt to asset ratio of 50% would have an equity multiplier of 2. When debt usage increases and a larger equity multiplier occurs, this can increase the ROE. The equity multiplier is “1” for an all-equity firm.

Example:

Companies A B C Industry Average Profit Margin 4.5% 6.0% 3.0% 5.0% Asset Turnover 1.8 1.5 3 2 Return on Assets 8.0% 9.0% 9.0% 10.0% What does this tell us about the profitability of the three companies? Company A is below average in both cost control and ability to generate sales. Clearly, Company B is controlling its costs better than the others. However, Company B has a low asset turnover. Its focus should be on producing sales. Company C has a large asset turnover but a low profit margin. Its focus should be on cost control. Continuing the analysis with return on assets and the equity multiplier, we find the following: Companies A B C Industry Average Return on Assets 8.0% 9.0% 9.0% 10.0% Equity Multiplier 4 2 1.33 2 Return on Equity 32 .0% 18 .0% 12 .0% 2 0.0% What has happened to the relative rankings? Company A has moved to the top because of its use of debt. Company C is run very conservatively, so it is penalized. Which company is best? From the use of debt point of view, there is no one answer — it is a risk/return trade-off. What would happen to Company C’s ROE if C used an average amount of debt? It would rise to 18%.