DuPont Analysis by NTA

DuPont Analysis

DuPont Analysis – The stock market is one of the most popular investment avenues. In fact, more and more investors are investing money in the stock market because of higher returns.Furthermore, the investors invest in a stock after conducting research and analysis. It is very important that the investors invest money after conducting a fundamental and technical analysis of the company. Otherwise, they may lose their money. One way of finding the right company for investment is conducting DuPont Analysis.

 

In this article, we shall understand the concept of DuPont Analysis.

 

Let us first learn the meaning of DuPont Analysis

What is DuPont Analysis?

DuPont Analysis is a financial ratio analysis that determines the ability of the company to increase its return on equity ratio. It breaks down the return on equity into a detailed form to overcome the shortcoming of ROE. The DuPont Analysis model has three components for return on equity calculation. They are asset turnover, profit margin and financial leverage.

 

Let us now see the formula for calculation of DuPont model.

Formula for DuPont Model

As we read above that DuPont Model overcomes the drawbacks of ROE. Therefore, let us arrive at the formula for DuPont model.

Equation 1:

ROE = Net Income / Average Equity Shareholders

Equation 2:

On multiplying and dividing the equation 1 with net sales and average total assets

 

ROE = Net Income / Average Equity Shareholders x Net Sales / Net Sales x Average Total Assets / Average Total Assets

Equation 3:

On multiplying the equation 1 and 2, we get

 

ROE = Net Income / Net Sales x Net Sales / Average Total Assets x Average Total Assets / Average Equity Shareholders

 

  • Profit margin is also known as net profit margin. The net profit less preference dividend must be used for calculation.
  • Average total assets are the total of the assets at the beginning and at the end of the period, divided by 2.
  • The shareholder’s equity and total asset value can be found in the balance sheet. The net sales and net income are available in the income statement.

Now let us see the interpretation of DuPont model

Interpretation of DuPont Model

The above formula can be broken down into a simpler form. Let us understand the interpretation of DuPont Model formula.

 

  • Operational efficiency measures the profit margin. The formula is = Net Income / Sales
  • Asset turnover measures the asset utilization. The formula is = Net Sales / Assets
  • Equity multiplier measures the financial leverage. The formula is = Assets / Shareholders Equity

On the basis of the above three points of interpretation, the DuPont Model calculates the performance of a company. In addition, the DuPont analysis suggests that how a company can raise its return on equity with efficient use of assets or increasing the turnover of the company or by maintaining a higher profit margin.

 

The next question that arises in our minds is what the use of DuPont Analysis is. Now, let us see the use of DuPont Model.

Use of DuPont Analysis

As we know that DuPont Analysis is a better form of Return on Equity equation. Therefore, the DuPont analysis is useful for making the right investment decisions. It helps in understanding the position of a company in a better way. Like for example, if the company is earning good profits due to the high margin on sales or efficient utilization of assets, the operational efficiency or asset turnover ratio shall improve. This means that the company is performing well and the investors can invest in such company. While if the financial leverage increases leading to higher return on equity suggests that increase in profits is not due to good strategy but due to financial strategy. Hence, it is a risky investment.

 

For learning purpose, the below ROE chart shall help you understanding the DuPont Analysis in a better way.

DuPont Analysis Chart

DuPont Analysis Chart

Now let us take an example to understand the calculation of DuPont Analysis––

Example of DuPont Analysis

Suppose there are two companies and we have to find out which company presents a better investment opportunity?

Ratio Company X Company Y
1.Operating Profit Margin Ratio .40 .24
2.Asset Turnover Ratio .20 .20
3.Financial Leverage 4 6.66
ROE (1*2*3) .32 .32

In the above case, both the companies are having Return on Equity as .32. Therefore, this may lead to the conclusion in investor’s mind that both the companies are same in terms of investment. However, this is not the case. The operating margin on company X is better in comparison to company Y. Therefore, investment in company X shall be much safer.

About Nifty Trading Academy

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