Dupont Ratio Analysis

BestBooks and GreatBooks are two retail companies selling all kinds of books. Given below are some of their financial data in 2011 and 2012

BestBooks 2011 2012
Total Assets 1000 1500
Debt 0 0
Equity 1000 1500
Sales 2000 2200
Interest Expense 0 0
Net Income 500 550
GreatBooks 2011 2012
Total Assets 1000 1250
Debt 800 800
Equity 200 450
Sales 1500 1650
Interest Expense @ 6.25% 50 50
Net Income 250 264

Return on Equity

Return on Equity measures the rate of return that shareholders get for investing their money in the company.

Return on Equity (ROE) = Net Income / Average Shareholder’s Equity

Why should we take the average of shareholder’s equity? Shareholders equity is a balance sheet item. All the balance sheet items are for a point in time. Net income is an item present in the income statement. All the income statement items are for a period. Hence to get a reasonable estimate of shareholder’s equity for the entire year we take the average of the current and the previous year.

ROE for Best Books in 2012
                    = Net Income / Average(Shareholders Equity 2012, Shareholders Equity 2011)
                    = 550 / Average(Shareholders Equity 2012, Shareholders Equity 2011)
                    = 550 / ((1500 + 1000) / 2)
                    = 550 / 1250
                    = 44%

GreatBooks has an interest expense of $50 and it resulted in reducing their net income. As a shareholder we want to measure the return without any effects of interest expense. We need to adjust the net income to add back the interest expense. This is called as De-Levered Net Income. Interest expense reduces your profit and also the taxes you owe. If we add this back we need to adjust it for taxes. For 2012 let us assume that the tax rate is 35%.

  De-Levered Net Income for 2012 = Net Income + (1 - taxRate) * Interest Expense
                                 = 264 + (1 - 0.35) * 50
                                 = 264 + 50 - 17.5
                                 = 296.5

  ROE for Great Books in 2012 
        = De-Levered Net Income / Average(Shareholders Equity 2012, Shareholders Equity 2011)
        = 296.5 / Average(Shareholders Equity 2012, Shareholders Equity 2011)
        = 296.5 / ((450 + 200) / 2)
        = 296.5 / 325
        = 91.23%

ROE for Great Books is 91.23% which is much higher than BestBooks which has an ROE of 44%. Can we conclude that shareholders are better of putting their money in Great Books? Not so fast. We need to break down ROE into different pieces to really understand the details.

Dupont Analysis

ROE can be affected by three different components

  1. Profitability – This is measured by (Net Income / Sales). For one dollar of sales how much profit is earned by the company.
  2. Efficiency – This is measured by (Sales / Average Assets). For a dollar of assets how much sales does the company make. Since assets is a balance sheet item we need to average them.
  3. Leverage – This is measured by (Average Assets / Average Equity). For a dollar of equity how much assets does the company have. Both assets and equity are balance sheet items and hence we need to average them.

DuPont Corporation in the 1920s came up with this idea of measuring their company’s performance and it rewrote ROE as given below. Hence the name of this analysis is Dupont.

ROE = Profitability * Efficiency * Leverage
ROE = (Net Income / Sales) * (Sales / Average Assets) * (Average Assets / Average Equity)

If any of the components go up then the ROE goes up. Let us now do a Dupont analysis for BestBooks

ROE for Best Books 2012 = Profitability * Efficiency * Leverage

Profitability = Net Income / Sales
                = 550 / 2200
                = 0.25

Efficiency = Sales / Average(Assets 2012, Assets 2011)
            = 2200 / ((1000 + 1500) / 2)
            = 2200/ 1250
            = 1.76

Leverage = Average Assets / Average Shareholders Equity
          = ((1000 + 1500) / 2) / ((1000 + 1500) / 2)
          = 1

ROE for BestBooks 2012 = 0.25 * 1.76 * 1
                       = 44%

Let us do the Dupont analysis for GreatBooks

ROE for Great Books 2012 = Profitability * Efficiency * Leverage

Profitability = De-Levered Net Income / Sales
                = 296.5 / 1650
                = 0.18 (rounded)

Efficiency = Sales / Average(Assets 2012, Assets 2011)
            = 1650 / ((1000 + 1250) / 2)
            = 1650/ 1125
            = 1.47 (rounded)

Leverage = Average Assets / Average Shareholders Equity
          = ((1000 + 1250) / 2) / ((200 + 450) / 2)
          = 1125 / 325
          = 3.46 (rounded)

ROE for GreatBooks 2012 = 0.18 * 1.47 * 3.46
                           = 91.23% (without rounding)

From all this we can see the following

  1. Profitability – BestBooks earns 25 cents on a dollar of sales which is higher than GreatBooks which only earns 18 cents on a dollar.
  2. Efficiency – BestBooks turns over assets 1.76 times which is higher than GreatBooks turn over of 1.47.
  3. Leverage – BestBooks does not have any debt. Hence it is leverage factor is 1 and it does not affect its ROE. GreatBooks has a leverage factor of 3.46 and because of this the overall ROE of GreatBooks is inflated.
Profitability Efficiency Leverage
BestBooks 0.25 1.76 1
GreatBooks 0.18 1.47 3.46

By doing Dupont analysis we can clearly see that BestBooks business is better than GreatBooks.

Coach and Walmart

Coach is a marketer of fine accessories and gifts for women and men. Its product offerings include women’s and men’s bags, accessories, footwear, jewelry, etc. Take a look at their ROE

2008 2009 2010 2011 2012
Net Margin % 24.62 19.3 20.37 21.18 21.81
Asset Turnover (Average) 1.35 1.34 1.43 1.63 1.66
Financial Leverage (Average) 1.5 1.51 1.64 1.63 1.56
Return on Equity % 45.71 38.82 45.91 56.5 57.63

It has a very high return of equity averaging around 49%.  It sells high end luxury products which results in a very high profit margin. Also it has a good asset turn over ratio and a reasonable financial leverage. All these components contributes towards the high ROE.

On the other hand Walmart is a discount retailer which sells all kinds of products. Take a look at their ROE

Profitability 2008 2009 2010 2011 2012
Net Margin % 3.36 3.3 3.51 3.89 3.51
Asset Turnover (Average) 2.41 2.48 2.44 2.4 2.39
Financial Leverage (Average) 2.53 2.5 2.41 2.64 2.71
Return on Equity % 20.18 20.63 21.08 23.53 22.45

It has a decent return on equity averaging around 22%. How can a company with a low net profit margin can have a decent ROE? Since it sells the items at a cheap price it can clear its inventory faster and hence it has an excellent asset turnover ratio. Also it has a very high financial leverage which boosts its ROE.

You cannot compare Coach and Walmart as they are in different industries with different business models. But Dupont analysis shows us all the key factors that contributes to ROE.

Closing Thoughts

Dupont analysis helps us to dissect the components of ROE. By doing that we can ask better questions about why things are the way they are. In fact all the ratios does not provide us answers. It helps us to ask better questions.

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