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The DuPont analysis is a three or five steps breakdown of the ROE calculation developed by the DuPont company back in the20s. The common formula for ROE calculation Net Income/Shareholders Equity is too simple to tell the whole story behind the ROE value.
Essentially the three steps method allows the breakdown of the ROE calculation in three components which are:
Operating Efficiency > profit margin X
Assets Utilization Efficiency > Assets Turnover X
Financial Leverage >equity Multiplier = ROE or
ROE = (Net Income/Sales) x (Sales/Assets) x (Assets/Shareholders Equity)
The reason for this analysis is that it allows to identify if a high ROE is the results of a balanced management of the company or by instance, a poor operational management of the company and just an increasing leverage the beyond safety limit.
The five steps analysis introduces two other contributor to the ROE and analyses more in depth if the increase in leverage effectively increases the ROE to a point at which the increased interest expenses as result of borrowing might offset the leverage benefit:
ROE = [(EBIT/Sales) x (Sales/Assets) - (Interest Expenses/Assets)] x (Assets/Equity) x (1-Tax Rate)
DuPont equation also known as the DuPont analysis, DuPont Model, DuPont formula or the DuPont method is a method for assessing a company's return on equity (ROE) by breaking it down into three parts. The name comes from the DuPont Corporation that started using this formula in the 1920s.
This equation dissects the ROE to tell you how the company is achieving its ROE.
These are the three questions that the DuPont analysis can help you answer.
By referencing ROE alone, a company with a ROE of 20% could look like a fantastic opportunity, but when you take a deeper look, it could tell a completely different story.
Moreover, this analysis enables the analyst to compare different companies in similar industries or between industries.
