DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont framework, DuPont model or the DuPont method) is an expression which breaks ROE (return on equity) into three parts.
The name comes from the DuPont company that began using this formula in the 1920s. DuPont explosives salesman Donaldson Brown invented the formula in an internal efficiency report in 1912.
ROE = (Profit margin) *(Asset turnover) *(Equity multiplier) = (Net profit/Sales) *(Sales/Average Total Assets) *(Average Total Assets/Average Equity) = (Net Profit/Equity)
Profit/Sales*Sales/Assets = Profit/Assets*Assets/Equity
ROE = ROS*AT=ROA*Leverage
Profitability (measured by profit margin)
Asset efficiency (measured by asset turnover)
Financial leverage (measured by equity multiplier)
The DuPont analysis breaks down ROE (that is, the returns that investors receive from a single dollar of equity) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries).
The DuPont analysis is less useful for industries such as investment banking, in which the underlying elements are not meaningful. Variations of the DuPont analysis have been developed for industries where the elements are weakly meaningful.
DuPont analysis = Net profit margin x Asset turnover x Equity multiplier
Each of these factors represents the result of a separate formula. When you replace the factors in the DuPont analysis equation with the formulas that make up each component, the DuPont analysis equation looks like this:
DuPont analysis = (net income / revenue) x (sales / average total assets) x (average total assets / average shareholders’ equity)
Net profit margin
The net profit margin is a ratio that represents the percentage of profits a business has remaining for every dollar of revenue after it deducts its expenses. You can calculate the net profit margin by dividing a company’s net profits by its total revenues. When written as an equation, the formula for calculating net profit margin is:
Net profit margin = Net income / Revenue
Net profit margin is a common profitability measure. As a business’s net profit margin increases, its return on equity also increases. The primary concept of net profit margin is that a business can increase its profit margins by reducing its costs, increasing its prices or a combination of both.
Total asset turnover
Total asset turnover is a ratio that represents how efficient a business is at using its assets to make sales and generate revenue. To calculate total asset turnover, divide the company’s revenues by its average assets. The equation used to represent the total asset turnover formula is:
Total asset turnover = Revenue / Average assets
As a business’s total asset turnover ratio increases, its return on equity also increases. Typically, a company’s total asset turnover ratio inversely relates to its net profit margin. This means the higher a company’s net profit margin is, the lower its asset turnover rate is and vice versa.
This makes it possible for investors and financial decision-makers to accurately compare a company that uses a high-profit, low-volume business model to a similar company that uses a low-profit, high-volume business model. They can then use their comparison to determine which company is better at driving return on equity for its shareholders.
The equity multiplier measures a company’s financial leverage and represents the portion of a company’s return on equity ratio that results from debt. You can find a company’s equity multiplier by dividing its average total assets by its average shareholders’ equity. The formula for calculating the equity multiplier is:
Equity multiplier = Average assets / average equity
As a company’s equity multiplier increases, its return on equity ratio also increases. Ideally, a business uses enough debt to finance its operations and growth without having excess debt, which keeps its equity multiplier low. Sometimes a business tries to boost its return on equity ratio by taking on excess debt. By including the equity multiplier in its formula, the DuPont analysis model gives investors an accurate measure of the company’s financial leverage to use when making investment decisions.