What is the DuPont Analysis?
The DuPont analysis is a method for assessing a company's return on equity (ROE). It is also often called the DuPont identity. The DuPont analysis breaks down a company's ROE by analyzing asset efficiency or turnover ratio, operating efficiency and financial leverage—this approach measures a company's gross book value. In contrast, other analysis resources look at a company's net value to assess ROE, which doesn't analyze as deeply as the DuPont method and therefore may not be as accurate. The DuPont analysis was pioneered in large part by the DuPont Corporation, which was founded in the 1920s.
ROE refers specifically to the value a stockholder may expect from their holdings. It can be calculated simply by taking a company’s net income and dividing it by the shareholders’ equity. A high ROE is usually a good indicator that a company is worth investing in. This, however, can be misleading. A company may boost their ROE by taking on new leverage, or debt, but at the ultimate expense of the shareholder. By peering further beneath the surface of a company’s financial practices, the DuPont Analysis attempts to provide more reliable and, therefore, safe ROE calculations for investors.
To assess ROE, the DuPont Analysis measures how well a company manages its assets versus its leverage. This is done by measuring the turnover ratio of assets and comparing it with how much leverage the company is holding and taking on. It then analyzes a company's operating efficiency, which is determined by profit margin, or how much of its earnings a company is actually able to keep.
As opposed to the simplest way of calculating ROE, DuPont’s multi-faceted calculation may be better able to detect whether and where a company has financial baggage. As a result, an investor may be less likely to invest in a company that, though appealing on the surface, may ultimately have weak returns resulting from bad profit margins or bloated leverage. It also can help protect investors from putting money into companies that have artificially raised their ROE, perhaps by taking on more leverage, in order to pull in more investors.
The DuPont analysis may also be useful for a company wishing to take its own financial pulse. Executives may be aware that their company is under performing, but may need a method for finding the source of the problem. Using an assessment system such as the DuPont analysis may help company leaders locate the source of a financial problem so steps can be taken to rectify it.
The DuPont analysis may not be useful in analyzing all industries. For example, a bank may use assets and leverage differently than a retail chain does, which may make it difficult to obtain the best assessments for both industries using the same analysis method. For such cases, there are other thorough methods of analyzing ROE besides the DuPont method. For example, some investors use a 5-year method of assessing ROE, relying on time to detect any flaws in a company's financial practices.
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