While choosing which assets to include in a portfolio, an in-depth analysis of the investment alternatives is made. If one of the alternatives is an ownership share in a corporation, then it is observed that the DuPont ratio is the best tool used to analyze that investment.
The DuPont model was internally developed by Du Pont as a tool to measure its investment projects, but eventually became widely used as a financial tool. The DuPont analysis breaks down a company’s return on equity (ROE )into three components.
1. Profit margin as measured by net income as a percentage of sales
2. Asset turnover which is net sales divided by the total assets of a firm
3. Degree of financial leverage as measured by the equity multiplier which is the ratio of total assets financed by stockholders’ equity
In formula form, DuPont return on equity is
ROE = net income/total stockholders’ equity = Profit margin x Asset turnover x Equity multiplier
OR
ROE = net income/total stockholders’ equity = net profit/net sales x net sales/total assets x total assets/total stockholders’ equity
Profit margin indicates how efficient the company’s management is in operating the company and in controlling costs. Asset turnover, on the other hand, measures the efficiency of the company in generating sales for every dollar of asset. Lastly, the equity multiplier shows how leveraged a company is by computing how much financing stockholders provided for every dollar of asset.
Using the DuPont system in evaluating alternative stock investments helps investors in comparing why ROEs of these stocks differ by identifying the impact of operating efficiency, asset-use efficiency and financial leverage on the return on equity. It is not enough that each of these stock investment alternatives be ranked according to ROEs, but what contributed to their ROEs should also be analyzed.
Of course, the DuPont ratio and return on equity, for that matter, should not be used as the sole, investment analysis tool in deciding on what stock to include in a portfolio. Other tools such as the return on investment and cash flows as a percentage of sales, or any other income statement item, are just few of numerous financial tools that an investor can easily use in investment analysis.
Buying a stock is a serious commitment. You are committing a portion of your wealth. You are also committing a part of your dream of becoming financially independent. Hence, stock investment analysis should be taken very seriously.