Way back in the 1920s, DuPont gave us a useful way to measure a company's performance. The DuPont analysis was used to gauge a company's performance through its return on equity, or ROE, which is important for investors because it shows how profitable a company is for its shareholders. DuPont breaks down ROE into three parts:
ROE = net profit margin x asset turnover ratio x equity multiplier ratio
Net profit margin: This component gives us an understanding of how effectively a company can convert its revenues into earnings. Net margins vary across industries; what is high in one industry may not be in another.
Asset turnover ratio: This tells us how efficiently a firm converts its available assets to generate revenue. Companies with low profit margins generally tend to have higher asset turnover ratios.
Equity multiplier ratio: This tells us how much liability a company uses to finance its assets and what portion of ROE is driven by liability. Thus, a company could assume more debt to increase its ROE.
Significance of DuPont
The DuPont formula gives us a better understanding of a company's efficiency. Investors should know exactly where their money is coming from, and that's where the DuPont ROE analysis comes in.
Let's use the DuPont analysis to derive aftermarket retailer Advance Auto Parts'
| Metric |
LTM 2011 |
LTM 2010 |
|---|---|---|
| Net Margin | 5.92% | 5.43% |
| Asset Turnover | 1.75 | 1.77 |
| Equity Multiplier | 3.79 | 2.74 |
| Return on Equity | 39.2% | 26.3% |
Source: Capital IQ, a division of Standard & Poor's.
Advance’s net margin has increased in the past 12 months, while its asset turnover ratio has declined slightly during this period. The equity multiplier has shown the highest percentage change. The company's assets increased to $3.6 billion, up 8% from a year ago, while its equity has fallen to $764.3 million, down 28%. At the same time, the company has assumed more debt. Its total debt has gone up to $566.4 million, up nearly 57% from a year ago.
Let's now see what factors have affected ROE at Advance's peers.
| Company |
Net Margin |
Asset Turnover |
Equity Multiplier |
ROE |
|---|---|---|---|---|
| AutoZone |
10.37% |
1.39 |
(7.17) |
NM |
|
O'Reilly |
8.19% |
1.09 |
1.69 |
15.1% |
|
Genuine Parts |
4.44% |
2.18 |
1.95 |
18.9% |
|
Pep Boys |
1.86% |
1.28 |
3.28 |
7.9% |
Source: Capital IQ, a division of Standard & Poor's; NM = not meaningful.
AutoZone has the highest net margin in the list, but has a negative equity multiplier ratio since the company runs with negative equity. Genuine Parts has the highest asset turnover ratio and a high ROE of 18.9%.
We see that Advance tops the list with an ROE of 39.2%. However, this has resulted from a high equity multiplier as the company has taken on more debt. The company has added nearly 130 new stores in the last year or so. Plus, it is investing in its commercial and e-commerce businesses, which should deliver growth in the long run.
The Foolish bottom line
As the economic recovery has been slow, aftermarket retailers have profited as consumers have preferred to maintain their old cars rather than purchase new ones. Thus, Advance has reaped the benefits of a troubled U.S. economy. With the economic expansion still lacking vigor, we can expect Advance to keep profiting in the near term.
Now that we've broken down Advance's ROE using the DuPont analysis, we can see what is driving its ROE. This will give its investors, or those considering investing in the stock, a better idea of what is powering returns. To stay up-to-speed on all the top news and analysis on Advance Auto Parts, click here to add it to your stock Watchlist.
