The secret of finding great stocks for long term investment is to find stocks that have great ability to preserve investor’s capital and create a lot of wealth at the same time.
Though there are so many tools that will help you find such stocks, but one of the easiest one is the DuPont Analysis.
In this post, we will try to understand what is DuPont analysis and its inner workings.
What is DuPont Analysis? The Components:
DuPont Analysis, also known as DuPont Model, is based on return on equity ratio which determines a company’s ability to increase its Return on Equity.
DuPont analysis was created by Mr. Donaldson Brown in 1920, while he was working at DuPont Corporation (hence the name). DuPont analysis, in its early stage was used for measuring the management efficiency.
DuPont analysis breaks down the Return on Equity (ROE) part into smaller portions in order to investigate the root cause of Return on Equity (ROE).
It looks at three main components of the Return on Equity Ratio:
While Profit Margin measures the profitability of a business, Asset Turnover shows how efficiently the assets of the business are utilized to generate revenue.
Finally, Financial Leverage shows how is the business capitalized. In other words, financial leverage is a liquidity ratio that shows how much of a businesses’ total capital is funded by shareholders and how much by debt.
Using these three major parameters, DuPont analysis can measure the quality of any business.
Let us now move forward and understand the formula and working.
DuPont Analysis: Formula
The formula used in DuPont Analysis is an expanded form of Return on Equity (ROE).
The Formula for Return on Equity is as follows:
ROE= Net Income / Shareholders Equity
As mentioned earlier, DuPont Analysis uses three factors to analyze the quality of a business, Profit Margins Asset Turnover and Financial Leverage.
The formula is as follows:
ROE= Profit Margin * Asset Turnover * Financial Leverage
If you expand each of the components of the above formula, this is something that you will get.
As it is clear from the formula above, DuPont Analysis is simply an expansion of the ROE formula. If you cancel the Net sales and Total Assets, you will get back the formula for ROE.
Every one of these numbers can be easily found on various websites and annual reports of the company.
DuPont Analysis: Interpretation
DuPont Analysis, using three vital parameters of a business’s growth and sustainability, highlights the strengths of a business and at the same time points out any weakness present.
For Example, a business with high profit margins may look like a great investment, but if it has used excessive leverage (that is, it has lot of debt on its books), it may land into trouble if margins start to shrink, as the business has to keep paying its debt obligations, irrespective of whether it makes a profit or suffers a loss.
DuPont analysis can also be used to find the exact pain points of the business. For Example, if a business has low ROE, you can find the area where it is lagging behind, is it excessive leverage or poor asset turnover?
By understanding the exact issues, you can wait for things to get better in the future, and when things start to improve, you can make a decision to invest.
DuPont Analysis can also be used to compare two or more similar businesses, helping you find which one is better.
For Example, let’s say there are two companies, A and B, both of them have same Net Profit Margin of 15%, making it difficult for you to understand, which one is better.
In order to make a clear decision, you need to look at the other components of DuPont Analysis such as leverage.
If company A has a leverage ratio of 0.5 and Company B has a leverage ratio of 1.2, it clearly shows that Company B has higher leverage, making it a riskier investment compared to Company A.
Here is a simple Info Graphic that will help you understand the entire concept of DuPont analysis clearly:
Having learned the steps of DuPont analysis, let us take an example and see how we can use DuPont Analysis to compare and find better investment opportunities.
Let us analyze the Return on Equity of two companies X and Y, both of them have ROE of 9%. The Ratios of the two companies are as follows:
Company X is able to generate higher profit against each sales as it is evident in higher Profit Margins.
Although Company Y is selling products at a lower margins, it is able to sell at higher volumes which can be seen in its high Asset Turnover Ratio.
Finally, Company Y seems to be less risky investment because of low financial leverage.
Thus, DuPont Analysis helps you in comparing two or more similar companies, it gives you a complete view on quality of a business and measure the risk associated with the business model of each company.
Just like every other fundamental analysis model, DuPont Analysis also has some drawbacks which should be kept in mind while analyzing a business.
Some of the major pitfalls of DuPont Analysis are as follows:
It’s not suitable for absolute valuation:
Not exactly a drawback, but this definitely is a limitation. DuPont Analysis is used to compare two or more similar companies to find which one has better quality fundamentals. It cannot be used for absolute or standalone analysis of a company.
Does not take consider Valuation as a parameter:
No matter how good a company is, if you pay too much for it, it does not make a good investment.
While DuPont analysis is a great tool for analyzing the quality of a business, it does not take into account how cheap or expensive a company is in terms of valuation and if it is the right price to buy the stock.
Does not work for asset-light business models:
DuPont Analysis uses asset turnover as one of the parameters for analyzing the quality of a company, which can be crucial for many asset heavy businesses such as the ones engaged in manufacturing, power generation,iron and steel etc.
However, DuPont analysis may not be very useful for analyzing asset light businesses, such as IT, and new age online businesses, as almost all of them have very little assets but still generate large revenue.
DuPont analysis is a very powerful tool to analyze the quality of a business and its ability to generate capital. It analyzes some of the most crucial factors such as what is causing the rise or decline in ROE.
If a company is able to improve its Net Profit margins without taking any additional leverage, it demonstrates that company has better pricing power over its products where consumers/ clients of the business are willing to pay higher price for the [product/service offered.
In conclusion, all I can say is DuPont analysis is a function of ROE, and can give you great insights about the business if used with other stock evaluation and valuation frameworks.
This is a wrap on this post. I hope you found this article useful and knowledgeable. Thank You for reading.