As a shareholder, you probably want to know how well the company you're invested in is using your money. After all, shareholders' equity is a big contributor to many companies' financials. Return on equity (ROE) and the DuPont analysis that can be performed on this metric are one way to find out. Read on to learn how to look more deeply into this metric.
What is DuPont analysis?
The DuPont analysis is a type of financial analysis that opens up the hood on return on equity (ROE) and reveals just how well companies are using shareholder money, where improvements are being made, and where further improvement is needed.
The analysis was originally developed in the 1920s at the DuPont Corp. to help them better understand their own metrics. With the DuPont analysis, you can see exactly how each element of the model contributes to the company's ROE.
DuPont analysis versus return on equity (ROE)
The DuPont analysis will give you a company's ROE, but unlike a basic ROE calculation, the DuPont analysis looks deeper, examining each component of ROE to see how changes in those elements affect the ROE.
With the DuPont analysis, you can not only get an end ROE figure but also compare different financial reporting periods to one another to assess the company's performance. You can also use this model to compare one company to its competitors to see how it stacks up over time.
Components of the DuPont analysis
The DuPont analysis can be more or less complicated, depending on how much information you want to extract. But for beginning investors, we're going to just look at the three-step DuPont analysis, which consists of these elements:
The model uses these four components to create three pieces of data within the analysis on the way to calculating ROE:
- Net profit margin. The net profit margin is how much companies make on their offerings once all expenses have been taken into account. Obviously, this should be healthy, and it never hurts if it's growing.
- Asset turnover ratio. This ratio measures a company's efficiency in generating money from its assets. In theory, this should increase as usage of owned assets increases; replacing assets would also decrease this figure.
- Financial leverage ratio. The financial leverage ratio is a way to represent how much debt a company has relative to its shareholders' equity. More debt is almost never better, though zero debt can also point to a company that isn't using leverage to its advantage.
The three-step DuPont analysis
There are two types of DuPont analysis: three-step and five-step. Although the five-step method may be more comprehensive, the three-step will be easier for newer investors to calculate and analyze, so that's the equation we'll be using for our example.
The three-step version of the DuPont analysis looks like this:
ROE = (net income / revenue) * (revenue / total assets) * (total assets / shareholders' equity)
Another way to put this is:
ROE = Net profit margin * asset turnover ratio * financial leverage ratio
So, if:
Net income = $20 billion
Revenue = $700 billion
Assets = $250 billion
Shareholders' equity = $100 billion
ROE = ($20 billion / $700 billion) * ($700 billion / $250 billion) * ($250 billion / $100 billion)
ROE = (0.0285) * (2.8) * (2.5)
ROE = 0.1995 or 19.95%
But since the net profit margin = 0.0285 (or 2.85%), the asset turnover ratio = 2.8, and the financial leverage ratio = 2.5, we can also compare these figures to other years to see what's improved or worsened. For example, if net profit margin had decreased year over year in this analysis, that would certainly be a red flag to pay attention to, even if the asset turnover ratio had also decreased.
Related investing topics
A good ROE is generally between 15% and 20% but will vary by sector. More importantly, if this company's competitors had ROEs of 12.5% and 15%, you'd know that it likely manages its money much better than they do. You'd then be able to use the DuPont analysis to see where the breakdown is for the competition by comparing each section of the formula.
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