DuPont analysis breaks Return on Equity (ROE) into three parts: ROE = Net Profit Margin x Asset Turnover x Equity Multiplier. The split shows whether a company's ROE comes from profitability, from using its assets efficiently, or from financial leverage (debt). Two companies with the same ROE can look very different once you see which factor drives it. Donaldson Brown developed the equation at the DuPont Corporation in the 1920s, and MarketXLS offers a DuPont analysis template that calculates all three factors in Excel.
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Return on Equity
ROE measures the profits a company makes compared to the shareholder’s investment.
ROE = Net Income / Shareholders' Equity. A higher ROE means more profit per dollar of equity, but a high ROE can also come from debt: a company that funds assets with borrowing has less equity relative to its assets, which raises ROE and also raises risk. That is why ROE on its own can mislead, and why DuPont analysis decomposes it.
How to Calculate DuPont Analysis?
The Three-Step DuPont equation has additional components to calculating the ROE compared to the original ROE equation. It measures three factors of a company: Profitability, Efficiency, and Financial Leverage.ROE = Net Profit Margin x Asset Turnover x Equity MultiplierThese three factors are a result of three separate formulas:Net Profit Margin= Net Income/ revenueAsset Turnover= Sales / AssetsEquity Multiplier= Assets / Shareholders Equity
Return On Equity (ROE) vs. Return On Assets (ROA)
As said above, ROE is a measure of how much a business profits based on the amount of equity invested in the business. Return on Assets (ROA) is a measure of how much profits a business makes with respect to the total assets.
A difference between ROE and ROA is the denominator. The numerator “Net Income” is the same for both. The denominator of ROE is Shareholder’s Equity which is equal to Assets – Liabilities. While ROA’s denominator is Total Assets = Shareholder’s Equity + Liabilities.
Looking at these two equations we see that ROA and ROE are actually equal to each other especially when the company’s liabilities are zero which leads to equity equals assets. To see the difference between ROE and ROA, we need to use ROE’s DuPont Analysis equation.
The image above shows that the first half of the ROE equation is ROA because if you cancel the sales then it becomes Net Income/Assets. Financial leverage, also known as equity multiplier, is the main differentiator between ROE and ROA. When a company takes on debt, its assets grow while shareholders' equity stays the same, so the equity multiplier (Assets / Equity) rises and ROE rises with it. Both ROE and ROA are profitability ratios that are important to consider when looking at a company’s performance.
Using the MarketXLS Template
The MarketXLS DuPont Analysis template calculates all three DuPont factors in Excel, so you do not have to build the formulas yourself.
The DuPont template calculates the ROE of all three factors, thereby reducing your workload. You can use it to compare ROE between multiple companies or between multiple years.
Here is a link to the template MarketXLS – DuPont Analysis Template
Conclusion
DuPont analysis shows investors which of the three factors is driving ROE. A DuPont Analysis will show us what is changing in the company and where exactly are they doing better or lagging. If a company is doing worse than its competitors, you can check whether it has a high cost, thereby decreasing net profit margin or lowering financial leverage. Use it alongside other ratios, not as a stand-alone verdict on a company.
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Image of DuPont Model equation
