DuPont analysis, which is also known as the DuPont identity or the DuPont model, is a method you can use to break down your company’s return on equity into three parts so you can have a better understanding of its value. This model doesn’t simply focus on your company’s net income. Instead, it breaks down return on equity in a way that allows you to focus on various aspects of your company’s operations to increase its value over time. Companies with shareholders can use the DuPont analysis to show shareholders a breakdown in their return on equity.
Basic Return on Equity
The return on equity ratio is a profitability ratio that measures your company’s ability to generate profits from shareholders’ investment. This ratio is calculated as:
Return on equity = net income / shareholders’ equity.
For example, assume your company has net income of $500,000 and shareholders’ equity of $5 million. The return on equity is:
$500,000 / $5 million = 10%
Even though this number is helpful in analyzing your company’s return on equity, the DuPont method shows a much more detailed picture.
The DuPont Analysis Formula
The DuPont analysis breaks return on equity into three major components:
- Operating efficiency as measured by profit margin
- Asset use efficiency as measured by total asset turnover
- Financial leverage as measured by the equity multiplier
These individual pieces are calculated as:
- Profit margin = net income / sales
- Total asset turnover = sales / assets
- Equity multiplier = assets / shareholders’ equity
Taken as a whole, the DuPont formula is:
Return on equity = profit margin x total asset turnover x equity multiplier
This breaks down into:
Return on equity = (net income / sales) x (sales / assets) x (assets / shareholders’ equity)
Example DuPont Calculations
Let’s say there are two companies. Over one year, both companies have a 45% return on equity. On the surface, both may seem very similar since they have equal return on equity ratios, but upon further analysis using the DuPont method, it is shown they are very different.
Assume the following data for Company A:
- Net income = $90,000
- Sales = $300,000
- Assets = $600,000
- Equity= $200,000
Assume the following data for Company B:
- Net income = $22,500
- Sales = $150,000
- Assets = $25,000
- Equity = $50,000
The calculations for the components of return on equity for Company A are:
- Profit margin = $90,000 / $300,000 = 30%
- Total asset turnover = $300,000 / $600,000 = 50%
- Equity multiplier = $600,000 / $200,000 = 3
The calculations for the components of return on equity for Company B are:
- Profit margin = $22,500 / $150,000 = 15%
- Total asset turnover = $150,000 / $25,000 = 600%
- Equity multiplier = $25,000 / $50,000 = 0.5
The DuPont analysis for each is:
Company A return on equity = 0.3 x 0.5 x 3 = 45%
Company B return on equity = 0.15 x 6 x 0.5 = 45%
It is very clear these companies are different. Company A has a much stronger profit margin but is not utilizing its assets as well as Company B. Also, Company A has less leverage than Company B. The DuPont analysis paints a much clearer picture and would give you much better data about your company’s performance.
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