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DuPont analysis

DuPont analysis is an expression which breaks ROE (Return On Equity) into three parts.
With this method, assets are measured at their gross book value rather than at net book value in order to produce a higher return on equity (ROE). It is also known as “DuPont identity”.
A type of analysis that examines a company’s Return on Equity (ROE) by breaking it into three main components: profit margin, asset turnover and leverage factor. By breaking the ROE into distinct parts, investors can examine how effectively a company is using equity, since poorly performing components will drag down the overall figure. To calculate a firm’s ROE through Du Pont analysis, multiply the profit margin (net income divided by sales), asset turnover (sales divided by assets) and leverage factor (total assets divided by shareholders’ equity) together. The higher the result, the higher the return on equity.

DuPont analysis tells us that ROE is affected by three things:
– Operating efficiency, which is measured by profit margin
– Asset use efficiency, which is measured by total asset turnover
– Financial leverage, which is measured by the equity multiplier

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. New asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is underperforming

Posted by On 19/11/2009 Filed in: General Tags: , , , , ,
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