DuPont Analysis: How To Analyze Return On Equity
One of the things that I look when picking stocks is a company’s Return On Equity. The higher the number, the better.
Although that’s the rule, a higher number doesn’t always equate to a better investment. This is because it is affected by profitability and financial leverage.
Analyzing the ROE formula shows that if Net Income increases assuming Shareholder’s Equity remains constant, ROE also increases. The same is true if Equity decreases because of debt and Net Income stays constant.
Common sense will tell us that a higher RoE based on high earnings is a better investment than a company who borrowed more money. To determine which of these two is responsible for the increase and decrease of RoE, we use DuPont Analysis.
In this post, I’ll briefly discuss how Dupont Analysis can help you analyze a company’s Return On Equity.
What Is DuPont Analysis
DuPont Analysis is a method of performance measurement that breaks down Return on Equity into three parts; Net Margin, Asset Turnover Ratio and Equity Multiplier.
It tells us how much of the ROE is due to leverage, operating profitability and asset turnovers.
The formula is as follows;
Return on Equity (%) = Net Margin x Asset Turnover Ratio x Equity Multiplier
Where (expressed in %);
- Net Margin = Net Income / Revenue
- Asset Turnover Ratio = Revenue / Total Assets
- Equity Multiplier = Total Assets / Shareholder’s Equity
Net Margin is the earnings after all expenses, taxes, interests and dividends are paid out in relation to revenue. It tells us how profitable a company is.
The Asset Turnover Ratio measures a company’s effectiveness in is using its assets to generate revenue. A higher percentage means a better performing company.
Lastly, the Equity Multiplier measures financial leverage. A higher percentage suggests a highly leveraged company.
DuPont Analysis Application
Let’s try some examples to understand this formula.
In 2014, Cebu Pacific Air (CEB) reported a Return on Equity of 3.96%. In 2015, it reported a 17.58% RoE. This translates into a 344% growth in just one year. This is unusual. This sudden increase should be taken with careful analysis. To determine if the sudden growth is caused by high profitability or financial leverage, we’ll break down the RoE using DuPont Analysis.
In 2014, Cebu Pacific Air (CEB) reported these following data in their financial statements;
- Revenue – Php 52,000,018,310
- Net Income – Php 853, 498,216
- Total Assets – Php 76,062,258,808
- Shareholder’s Equity – Php 21,538,804,187
Let’s calculate the three parts;
Asset Turnover Ratio = 52,000,018,310/76,062,258,808 = 68.37%
Equity Multiplier = 76,062,258,808/21,538,804,187 = 353.14%
Let’s now calculate the same items using the 2015 financial statements. The data are shown below;
- Revenue – Php 46,142,206,688
- Net Income – Php 4,387,225,875
- Total Assets – Php 84,828,582,189
- Shareholder’s Equity – Php 24,955,195,156
Asset Turnover Ratio = 54.39%
Equity Multiplier = 339.92%
We can see that the Net Margin grew 479%, Asset Turnover Ratio declined by 20% and Equity Multiplier by 4%. Thus, we can conclude that the sudden increase in the Return on Equity is caused by the increase in income rather than debt.
Here’s another example.
Xurpass’ (X) Return on Equity increased to 27.90% from the previous of 12.31%. That’s a 126.71% growth! These numbers require a further investigation so let’s breakdown the RoE in each period covered.
- Revenue – Php 378,315,389
- Net Income – Php 182,070,562
- Total Assets – Php 1,654,458,644
- Shareholder’s Equity – Php 1,479,294,424
- Revenue – Php 898,374,300
- Net Income – Php 221,059,181
- Total Assets – Php 3,394,373,415
- Shareholder’s Equity – Php 792,229,344
Here are the calculated results.
Net Margin = 48.13%
Asset Turnover Ratio = 22.87%
Equity Multiplier = 111.84%
Net Margin = 24.61%
Asset Turnover Ratio = 26.47%
Equity Multiplier = 428.46%
We can see that the Equity Multiplier increased to 428.46% from the previous year of 111.84%. This translates into a 283.10% growth suggesting that the company took on more debt rather than increasing earnings.
This is an example of a company that’s highly leveraged. The increase in RoE is not because of high profits but rather a higher debt incurred to finance the purchase of assets. In a value investor’s standpoint, this is not good.
The concept is simple; a company that shows a consistent high Net Margin and Asset Turnover Ratio is an indication of a well-managed company. A company that shows a consistent high Equity Multiplier is an indication of a highly leveraged company.
Return on Equity is one of Warren Buffett’s favorite number when it comes to finding good investments. A company with a durable competitive advantage exhibits consistent high returns on equities.
But not all companies with high returns are good companies.
By using DuPont Analysis, we can carefully single out these types of companies that are highly leveraged compared to those that are really profitable.
If you find a company that shows consistent high returns on equities, use this method to take a different approach. That way, you’ll make a better investment decision.
Try this out to your long-term investments to see if you are really investing in a company with a competitive advantage.
P.S. Data taken from www.morningstar.com