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Decoding DuPont Analysis

Return on equity (ROE) is a closely watched number among knowledgeable investors. It is a strong measure of how well the management of a company creates value for its shareholders. The number can be misleading, however, as it is vulnerable to measures that increase its value while also making the stock more risky. Without a way of breaking down the components of ROE investors could be duped into believing a company is a good investment when it's not. Read on to learn how to use DuPont analysis to break apart ROE and get a much better understanding about where movements in ROE are coming from. (To learn the basics and value of return on equity, check out Keep Your Eyes On The ROE.)

ROE: Simple, Perhaps Too Simple

The beauty of ROE is that it is an important measure that only requires two numbers to compute: net income and shareholders equity. ROE = net income / shareholder's equity If this number goes up, it is generally a great sign for the company as it is showing that the rate of return on the shareholders equity is going up. The problem is that this number can also rise simply when the company takes on more debt, thereby decreasing shareholder equity. This would increase the leverage of the company, which could be a good thing, but it will also make the stock more risky.

Three-Step DuPont
To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In the 1920s the DuPont corporation created a method of analysis that fills this need by breaking down ROE into a more complex equation. DuPont analysis shows the causes of shifts in the number. There are two variants of DuPont analysis, the original three-step equation, and an extended five-step equation. The three-step equation breaks up ROE into three very important components: ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier) These components include: Operating efficiency - as measured by profit margin. Asset use efficiency - as measured by total asset turnover. Financial leverage - as measured by the equity multiplier.

The Three-Step DuPont Calculation Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get: ROE = (net income / sales) * (sales / shareholder's equity) We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont identity: ROE = (net income / sales) * (sales / assets) * (assets / shareholder's equity) This equation for ROE, breaks it into three widely used and studied components: ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

We have ROE broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how effectively the company makes use of its assets), and equity multiplier (a measure of how much the company is leveraged). The usefulness should now be clearer. If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the company. However, if the equity multiplier is the source of the rise, and the company was already appropriately leveraged, this is simply making things more risky. If the company is getting over leveraged, the stock might deserve more of a discount, despite the rise in ROE. The company could be under-leveraged as well. In this case it could be positive, and show that the company is managing itself better. (Learn to take a deeper look at a company's profitability with the help of profit-margin ratios in The Bottom Line on Margins.) Even if a company's ROE has remained unchanged, examination in this way can be very helpful. Suppose a company releases numbers and ROE is unchanged. Examination with DuPont analysis could show that both net profit margin and asset turnover decreased, two negative signs for the company, and the only reason ROE stayed the same was a large increase in leverage. No matter what the initial situation of the company, this would be a bad sign.

Explanation of third component of 'Leverage'

1. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10. 2. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders. Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.