Friday, June 1, 2012

The Du Pont Identity

DuPont analysis (also called the DuPont identity, DuPont formula , 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 investigate 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 a formula for calculating the return on assets and Assets divided by Total Equity is known as the Equity Mulitplyer.

Continuing to rewrite this ROE formula [remember it's (Net income/ Assets) * (Assets/Total Equity)] we multiply it by Sales/Sales and rearrange everything as follows: Return on Equity is: (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.

All these mathematical shenanigans show us that return on equity is influenced by three things:

1. The profit margin, which is a way of measuring operating efficiency
2. Total asset turnover which measures how efficiently we make use of our assets
3. The equity multiplyer which tells us how leveraged the firm 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 pension liabilities in 1992 basically destroyed GM's book equity. The moment the book equity was decimated, ROE amplified dramatically.

A simple calculation of return on equity may just be easy, but it does not supply you with the whole picture. If a company's ROE is lower than its competitors, DuPont analysis may help to show where the corporation is falling behind. It can also shed light on how a company is lifting its ROE. DuPont analysis helps significantly broaden understanding of ROE but the most crucial aspect is to examine carefully and calculate sparingly.

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