Dupont analysis

A simple financial analysis to find out a companies quality and comparing its quality to other companies

Introduction

The Dupont analysis is a financial ratio that measures the financial performance of a company. It is a great tool for comparing companies from different industries. It's also very useful for comparing companies within the same industry, as it gives you a quick overview of how your company compares to its competitors.

For example, if you're interested in investing in a particular stock and want to see how it compares against other stocks on the market, the Dupont analysis can be used as an initial test of the quality of a company and what it does better or worse than its peers.

Dupont analysis involves calculating the financial health of a company based on its return on equity (ROE), financial leverage, return on assets, profit margins, and capital turnover. The technique can be used to assess the market value of two or more companies in the same industry or different sectors.

Dupont is a powerful analysis because it visualizes two characteristics that investors evaluate when looking for quality in a company; profitability and asset lightness. Both are important and can give testimony of comparative advantage over other companies.

Let me go through the action tree from the top.

Return on Equity = Return on Assets * Financial Leverage

Financial Leverage = Total Assets / Equity

Return on Assets = Profit Margins * Capital Turnover

Profit Margins = Net Profit / Sales

Capital Turnover = Sales / Total Assets

Return on equity (ROE)

Return on equity (ROE) is a measure of the amount of money earned by a company's shareholders in relation to the amount of equity put into the company. It's calculated as net income divided by shareholder equity:

ROE = Net Income / Shareholder Equity

ROE can be used to compare companies within an industry and across industries, but it isn't desirable for comparing private and public firms because different accounting rules apply when calculating earnings for private versus public companies.

Financial leverage

The financial leverage ratio is a measure of the risk associated with the use of debt. It reflects how much debt is used to finance assets, and it's calculated by dividing total assets by equity.

Financial leverage = Total Assets / Equity

Return on assets (ROA)

Return on assets (ROA) is a measure of the efficiency of a company's assets. This metric shows how much profit is generated from each dollar invested in the business. To calculate ROA, divide net income by total assets and express it as a percentage:

• Net Profit = Total Amount Earned in Company

• Total Assets = Items that have Value to the Business, such as Cash, Assets (such as equipment), Accounts Receivable, Buildings, or Land.

ROA = Net Profit / Total Assets

Profit margin

Profit margin says how profitable a company is by expressing how much of every dollar that comes in stays on the bottom line. Profit margin is calculated by dividing net profit by sales.

• Net Profit = Total Amount Earned in Company

• Sales = Total Amount of Sold Goods and Services

Profit Margin = Net Profit / Sales

Capital turnover

Capital turnover expresses how many times the capital has been used in the company. A company wants to have a high capital turnover, which means it needs a lower amount of capital than a company with a low capital turnover. Capital turnover gives an indication of how efficient one company is with its capital and how asset-light it is, which can result in an advantage over the competition. If two companies (company A and B) have the same profit margins, then company A with the higher capital turnover will achieve a higher return on capital for the investors than company B. Capital turnover is calculated by dividing sales by total assets.

• Sales = Total Amount of Goods and Services Sold

• Total Assets = Items that have Value to the Business, such as Cash, Assets (such as equipment), Accounts Receivable, Buildings, or Land.

Capital Turnover = Sales / Total Assets

Dupont analysis in a context

Michael Mauboussin and Dan Callahan, CFA at Morgan Stanley has come out with an article named “Return on Invested Capital”. It is a treasure for anyone who wants to learn more about investment capital and if you want to learn more about it you should read this article. You can find the article here.

The article is not about Dupont analysis but has a very insightful graph on the drivers in ROIC. (which also can be used in a Dupont analysis, you just use invested capital instead of total assets and NOPAT [Net Operating Profit After Tax] margin instead of profit margin).

We can here see how some companies can have high ROIC. For example, the retail giants Target, Walmart, Home Depot, Nike, and Amazon has a high ROIC due to high invested capital turnover. Meanwhile, software companies such as Oracle, Mastercard, Microsoft, Meta, Alphabet, Qualcomm, and Apple have high NOPAT margins.

It is very interesting how Mauboussin and Callahan have also made two rings and written cost leadership and differentiation leading back to two of the ways Porter saw a company getting a competitive advantage. If you want to read more about Porter and his Power Model you find my article here.

Conclusion

Let’s wrap up this post by looking at a few other Dupont analysis notes:

First, it’s important to remember that using the formula is just one way to analyze a company. There are many other ways you can do it, and they will all be different depending on what information you have available or what type of industry you want to analyze. The formula itself is flexible enough that you can adjust it according to what works best for your needs; however, it is recommended to stick with the basics when doing so!

Second, remember that while Dupont analysis can be used in many industries and for many purposes (like comparing two companies), it does not work well as an absolute measure because ratios like return on equity tend to vary based on industry type as well as company size. This means that if you're comparing companies across different sectors then don't expect these ratios to come out exactly equal or even close to one another!