The Du Pont Identity
DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont Model or the DuPont method) was discovered by the DuPont Company ca. 1920. Analysts of corporate finance use the formula for return on equity (ROE) but adjusts it to analyze other aspects of a company’s performance.
Return on Equity is calculated as Net income divided by Total Equity. The result of this division will not change if we multiply it by the quotient of assets divided by assets (which is 1). Having done this we could rewrite the ROE formula as (Net income/ Assets) * (Assets/Total Equity). Net income divided by Assets however is the formula for calculating the return on assets and Assets divided by Total Equity is known as the Equity Mulitplyer.
Continuing to rewrite some of our ROE formula [remember it was (Net income/ Assets) * (Assets/Total Equity)] we multiply it by Sales/Sales and rearrange everything as follows: Return on Equity equals: (Net Income / Sales) * (Sales/Assets) * (Assets/Total Equity). (Net Income / Sales) is the Profit Margin, (Sales / Assets) is total asset turnover and (Assets / Total Equity) is the Equity multiplier.
A lot of these mathematical shenanigans show us that return on equity is influenced by three factors:
1. The profit margin, which is a measure of operating efficiency
2. Total asset turnover which measures how efficiently we employ our assets
3. The equity multiplyer which tells us how leveraged a company is.
Interpreting ROE values can be tricky. Take for example GM which improved ROE from 12. 1 percent in 1989 to 44.1 percent in a four year period. Its profit margin however had decreased from 3. 4 to 1. 8 percent, hence
the improvement in ROE was not caused by an improved operating efficiency.
How then was it possible for GM’s ROE to rise sharply?
The answer is that accounting treatment of retirement liabilities in 1992 basically wiped out GM’s book equity. Once the book equity was decimated, ROE increased dramatically.
A simple calculation of return on equity may very well be easy, but it does not give you the whole picture. If a company’s ROE is lower than its competitors, DuPont analysis can help to show where the company is falling behind. It can also reveal how a company is lifting its ROE. DuPont analysis helps significantly broaden understanding of ROE but the main aspect is to assess carefully and calculate sparingly.
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