Gain Deeper Insight

The problem with this number is that while it tells you whether the company's profitability has gone up or down, it does not shed light on the company's strengths and weaknesses. It does not tell you what went into producing that outcome. For instance, a company's high RoE may have been achieved by increasing leverage (taking on more debt), which would in turn increase the stock's risk level. Looking at RoE alone will not reveal this.

In the 1920s, DuPont Corporation created a method of analysis to enhance one's understanding of RoE. It breaks down RoE into a complex equation. There is one primary method of DuPont analysis while the rest are variations. The basic analysis is a three-step calculation, while the variations tend to have more steps, depending on the analyst's requirement.

The three-step DuPont analysis
The three-step calculation focuses on operating efficiency, asset-use efficiency and financial leverage. Take the RoE equation: ROE = net profit / shareholder's equity and multiply the right-hand side by (sales / sales).

RoE = (Net profit/sales) * (sales/shareholder's equity)

Now there are two components. The first is net profit margin (net profit/ sales), and the second is equity turnover ratio (sales/shareholder's equity).

If equity turnover ratio is further multiplied by (assets / assets), we get:

RoE = (Net profit/sales) * (sales/assets) * (assets/shareholder's equity)

The above equation has three major components that help understand a company's performance:

RoE = (Net profit margin) * (Asset Turnover) * (Financial leverage ratio)

Explaining the ratios
Net profit margin shows how much profit the company earns on every rupee of sale that it makes. Comparing this ratio for companies belonging to the same industry is useful. A higher profit margin indicates a more profitable company that has better control over its costs.

Asset turnover ratio is a measure of how efficiently the company utilises its assets to produce its revenue. This ratio may be compared vis-à-vis that of peers and also against historical numbers.

As for financial leverage ratio, though it is not an accurate measure, it shows how much of the company's assets are financed by equity. A low number indicates that the company has taken debt to finance its assets.

Thus we see that DuPont analysis gives a far deeper insight into a company's performance than RoE alone does. It tells you whether the company has good control over its costs, whether it utilises its assets efficiently, and whether its reliance on debt is within limits or excessive.

Depending on the analyst's needs, more variations of DuPont analysis can be employed.

Keep in mind that when you use DuPont analysis, always compare the ratios that it yields with the ratios of other companies belonging to the same industry. You can also compare these ratios with historical numbers of the same company.

Finally, DuPont ratio offers a way to get a snapshot view of a company's performance on various parameters. Strengths and weaknesses can be identified and corrective action, if needed, can be initiated promptly.

This article was originally published on October 08, 2010.