of dupoint analysis

more in-depth knowledge of ROE is needed

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:

ROE = (net profit margin) * (asset turnover) * (equity multiplier)

These components include:

• Operating efficiency – as measured by profit margin.
• Asset use efficiency – as measured by total asset turnover.
• Financial leverage – as measured by the equity multiplier.

The DuPont Corporation created its method for analyzing return on equity in the 1920s. Today, two variants are taught in finance programs—the original three-step model and an extended five-step model.

This model was developed to analyze ROE and the effects different business performance measures have on this ratio. So investors are not looking for large or small output numbers from this model. Instead, they are looking to analyze what is causing the current ROE. For instance, if investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.

Once the problem area is found, management can attempt to correct it or address it with shareholders. Some normal operations lower ROE naturally and are not a reason for investors to be alarmed. For instance, accelerated depreciation artificially lowers ROE in the beginning periods. This paper entry can be pointed out with the Dupont analysis and shouldn’t sway an investor’s opinion of the company.

This model helps investors compare similar companies like these with similar ratios. Investorscan then apply perceived risks with each company’s business model.

The DuPont Analysis is important determines what is driving a company’s ROE; Profit margin shows the operating efficiency, asset turnover shows the asset use efficiency, and leverage factor shows how much leverage is being used.

The method goes beyond profit margin to understand how efficiently a company’s assets generatesales or cash and how well a company uses debt to produce incremental returns.

Using these three factors, a DuPont analysis allows analysts to dissect a company, efficiently determine where the company is weak and strong and quickly know what areas of the business to look at (i.e., inventory management, debt structure, margins) for more answers. The measure is still broad, however, and is not a substitute for detailed analysis.

The DuPont analysis looks uses both the income statement as well as the balance sheet to perform the examination. As a result, major asset purchases, acquisitions, or other significant changes can distort the ROE calculation. Many analysts use average assets and shareholders’ equity to mitigate this distortion, although that approach assumes the balance sheet changes occurred steadily over the course of the year, which may not be accurate either

DuPont analysis is a potentially helpful tool for analysis that investors can use to make more informed choices regarding their equity holdings. The primary advantage of DuPont analysis is the fuller picture of a company’s overall financial health and performance that it provides, compared to more limited equity valuation tools. A main disadvantage of the DuPont model is that it relies so heavily on accounting data from a company’s financial statements, some of which can be manipulated by companies, so they may not be accurate.

DuPont analysis is an equity evaluation approach that uses financial and leverage ratios that expand the profitability ratio of return on equity (ROE) into a more detailed and comprehensive measure. In addition to indicating the return on investment (ROI) for shareholders, DuPont analysis also factors in three important performance elements: profitability measured by profit margin, operational efficiency measured by asset utilization (specifically asset turnover) and financial leverage measured by the assets/equity multiplier. If ROE is higher due to improved operational efficiency or utilization of assets, this is commonly interpreted favorably by analysts. However, if the ROE for investors only improves due to a company using increased financial leverage, then the increased equity returns are not actually a result of increased profits, and the company may be overextending itself financially, making it a riskier investment.