The DuPont Equation, ROE, ROA, and Growth
As you read this section, you will learn about special ratios that address dividend growth, return on assets, and equity. You will be exposed to their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will read about the DuPont Equation (also known as the strategic profit model), which comprises multiple financial ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
The DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage.
Explain why splitting the return on equity calculation into its component parts may be helpful to an analyst
- By splitting ROE into three parts, companies can more easily understand changes in their returns on equity over time.
- As profit margin increases, every sale will bring more money to a company's bottom line, resulting in a higher overall return on equity.
- As asset turnover increases, a company will generate more sales per asset owned, resulting in a higher overall return on equity.
- Increased financial leverage will also lead to an increase in return on equity, since using more debt financing brings on higher interest payments, which are tax deductible.
- competitive advantage
something that places a company or a person above the competition
- A company has sales of 1,000,000. It has a net income of 400,000. Total assets have a value of 5,000,000, and shareholder equity has a value of 10,000,000. Using DuPont analysis, what is the company's return on equity? Profit Margin = 400,000/1,000,000 = 40%. Asset Turnover = 1,000,000/5,000,000 = 20%. Financial Leverage = 5,000,000/10,000,000 = 50%. Multiplying these three results, we find that the Return on Equity = 4%.
The DuPont Equation
DuPont Model: A flow chart representation of the DuPont Model.
The DuPont equation is an expression which breaks return on equity down into three parts. The name comes from the DuPont Corporation, which created and implemented this formula into their business operations in the 1920s. This formula is known by many other names, including DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit model.
Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage. By splitting ROE (return on equity) into three parts, companies can more easily understand changes in their ROE over time.
Components of the DuPont Equation: Profit Margin
Profit margin is a measure of profitability. It is an indicator of a company's pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company's bottom line, resulting in a higher overall return on equity.
Components of the DuPont Equation: Asset Turnover
Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate sales revenue or sales income for the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity.
Components of the DuPont Equation: Financial Leverage
Financial leverage refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that the company utilizes. As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company's capital structure leads to a higher return on equity.
The DuPont Equation in Relation to Industries
The DuPont equation is less useful for some industries, that do not use certain concepts or for which the concepts are less meaningful. On the other hand, some industries may rely on a single factor of the DuPont equation more than others. Thus, the equation allows analysts to determine which of the factors is dominant in relation to a company's return on equity. For example, certain types of high turnover industries, such as retail stores, may have very low profit margins on sales and relatively low financial leverage. In industries such as these, the measure of asset turnover is much more important.
High margin industries, on the other hand, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin. For high end fashion and other luxury brands, increasing sales without sacrificing margin may be critical. Finally, some industries, such as those in the financial sector, chiefly rely on high leverage to generate an acceptable return on equity. While a high level of leverage could be seen as too risky from some perspectives, DuPont analysis enables third parties to compare that leverage with other financial elements that can determine a company's return on equity.
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