Return on equity shows how effectively a company is earning money from each unit of
shareholders investment. But simply knowing ROE doesn’t highlight other important factors
like what’s really driving the ROE of a company? Is the company profitable? Is it efficient with
assets? Is it heavily leveraged?
At this point we take help from DuPont equation.
DuPont equation breaks down ROE into three major components:
ROE= Net profit margin * Asset turnover * Equity Multiplier
Or in words:
ROE= Profitability * Efficiency * Financial Leverage
In this context, net profit margin indicates a company's profitability, asset turnover reflects
its operational efficiency, and the equity multiplier represents its financial leverage.
In mathematical form,
Net Profit Margin = Net Income / Sales
Asset turnover = Sales / Total Assets
Equity Multiplier = Total Assets / Shareholders equity
Through this equation we can understand that the value of ROE can be arrributed to high
profitability or high efficiency or because of higher financial leverage. All of these factors
play an important role in analyzing the financial performance of a company. Let’s examine
them one by one.
The profitability factor shows how much net income a company generates in relation to its
sales. Net income reflects the actual profit the organization retains after all expenses. It can
be used for company chores such as purchasing properties, allocating for administrative
expenses and distributing to shareholders as dividend. Thus it is solely the property of a
company. If a company generates higher net income, it shows us that the company is good
in earning return on its investment. Whereas if a company books less net income, it shows
that the company is not earning expected return on investment.
The efficiency factor shows how efficient an organization is in managing its assets to
generate sales and subsequently profit. For this. Asset turnover ratio is useful because it
shows the portion of sales on total assets. The target of any company with a growing
mindset is to generate higher sales with the amount of assets it has. For this, it utilizes
these assets for several tasks such as purchasing better machineries, hiring skilled
manpower, purchasing top notch lands for power plants etc. All these utilization of assets
are directed towards generating higher value among customers. Because of better
differentiation strategies, customers start to like the brand. It creates goodwill which in turn
increase the sales of an organization. This indicates efficiency and a higher value of this ratio
indicates greater organizational efficiency,while a lower value suggests reduced efficiency.
The financial leverage part shows how much assets an organization is generating by
utilizing shareholders equity. i.e it shows the portion of assets on shareholders equity.
When any company collects shareholders equity, its target is to utilize it to the fullest to
generate profit through sales. For this, it modifies its processes to produce better products.
It also improves its efficiency through better machineries as well as better training for
manpowers. Thus, after it becomes able to generate profit through sales, it purchase assets.
This capacity is highlighted by equity multiplier. This ratio, when higher, reflects a greater
level of assets held by the company; when lower, it indicates a smaller asset base. Therefore,
it is an important component in DuPont analysis.
For example:
Let’s say a company has:
Net Income = $100,000
Sales = $2,000,000
Total Assets = $500,000
Shareholder's Equity = $250,000
Then:
Net Profit Margin = 10%
Asset Turnover = 4
Equity Multiplier = 2
ROE = 10% × 4 × 2 = 80%
This tells us the company’s 40% ROE comes from good profitability, strong operational
efficiency, and moderate use of debt.
Industry Comparison of DuPont Components
In the above list, there are different values of ROE for different industry. For tech industry,
the value of ROE is 24%. If we look more carefully, we can see that this value of ROE is
directed by higher profit margin of 20% compared to other industries. Other industries such
as Retail, Manufacturing and Banking have lower profit margin compared to tech industry.
But for retail industry, even if the profit margin is 5%, its ROE is higher than tech industry.
This is because the asset turnover ratio is way higher than that of tech industry. Also the
equity multiplier is higher. Thus, as a result, the ROE is higher.
Now lets evaluate manufacturing industry. Its asset turnover ratio and equity multiplier are
comparatively higher and also net profit margin higher by 10%. As a result, the ROE
becomes a whooping 30%. For Banking industry, the net profit margin is 15% which is less
than tech industry by 5%. Similarly, the value of asset turnover is 0.7, which is less by 0.1.
But its ROE is 84% because its equity multiplier is 8, which is higher from the tech industry
by 6.5. By evaluating above datas, we can clearly see that we need to evaluate three
factors sothat we can analyze what is the driving force behind ROE.
This is the significance of DuPont analysis.
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