The DuPont Equation

1. The DuPont Equation

The DuPont equation is a means of calculating return on equity (ROE) based on three components:

• Net profit margin
• Total asset turnover
• Financial leverage

In the DuPont equation, ROE equals profit margin multiplied by asset turnover multiplied by financial leverage, where each component can be broken down into further calculations.

formula to know

Return on Equity

ROE measures the rate of return on the ownership interest or shareholders’ equity of the common stock owners. It is a measure of a company’s efficiency in generating profits using the shareholders’ stake of equity in the business. In other words, ROE is an indication of how well a company uses investment funds to generate earnings growth. It is also commonly used as a target for executive compensation, since ratios such as ROE tend to give management an incentive to perform better.

hint

Returns on equity between 15% and 20% are generally considered to be acceptable.

1a. Components

By splitting ROE into three parts, companies can more easily understand changes in their ROE over time. Let’s take a closer look at the three components of the DuPont equation:

1. Profit margin: This is a measure of profitability. It is an indicator of a company’s pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall ROE.
2. Asset turnover: This is a financial ratio that is used to evaluate how effectively an organization is utilizing its assets to generate a profit. Organizations that typically have lower net margins will have higher total asset turnover, and vice versa for firms with higher net margins.
3. Financial leverage: This refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that it utilizes. As is the case with asset turnover and profit margin, increased financial leverage will also lead to an increase in ROE. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s capital structure leads to a higher ROE.

big idea

Expressed as a percentage, ROE is best used to compare companies in the same industry. The decomposition of ROE into its various factors presents various ratios useful to companies in fundamental analysis.

IN CONTEXT

As you are learning, ROE is a measure of how a company uses its shareholders’ equity in the business to earn a profit. Assume that Alphabet Inc., parent company to Google, has a current ROE of 26.04%. Even though that is an impressive ROE, Alphabet strives for continual improvement and wants to examine this return.

Using the ROE formula, Alphabet can only see a part of the story.



The problem with this equation is that ROE is multifaceted, and using this equation does not give the company or the investors the full picture. This is where the DuPont equation steps in. The DuPont equation dives deeper into the components of ROE, so the individual pieces can be studied, and potential action can be taken to improve one or many of the components. You can find the component pieces in Alphabet’s financial statements:



Now, let’s apply the DuPont formula to our example:



Using the component pieces of ROE, Alphabet can determine which, if any, of these parts can be worked on to increase the ROE.

1b. Potential Limitations

A high ROE does not necessarily mean that a company will see immediate benefits. Stock prices are most strongly determined by earnings per share (EPS) as opposed to ROE. EPS is the amount of earnings for each outstanding share of a company’s stock. EPS is equal to profit divided by the weighted average of common shares.

formula to know

Earnings Per Share

The true benefit of a high ROE comes from a company’s earnings being reinvested into the business or distributed as a dividend. In fact, ROE is presumably irrelevant if earnings are not reinvested or distributed.