The DuPont Model Return on Equity Formula for Beginners

Analyzing the Three Components of Return on Equity

DuPont Return on Equity Analysis
A DuPont return on equity analysis is an advanced way to calculate ROE from the income statement and balance sheet to identify the underlying components of how a business is generating its profit. John Lamb / Digital Vision / Getty Images

One of my all-time favorite financial tools is something known as a DuPont return on equity model.  More than perhaps any other single metric, an experienced investor or manager can look at a DuPont model ROE breakdown and almost instantly gain insight into the capital structure of a firm, the quality of the business, and the levers that are driving the return on invested capital.  It is akin to opening a car engine and seeing how the machinery is put together.


We touched a bit on the concept of return on equity, or ROE, in the investing lessons I wrote to help you understand how to analyze an income statement and balance sheet.  There, you discovered that return on equity is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt relative to equity are able to grow without large capital expenditures, allowing the owners of the business to take freshly generated surplus cash and deploy it elsewhere.  What many investors fail to realize, and where a DuPont return on equity analysis can help, is that two companies can have the same return on equity, yet one can be a much better business with much lower risks.  This can have incredible consequences for your portfolio's returns over long periods of time as the better business is able to generate more free cash flow or owner earnings.


The History of the DuPont Return on Equity Calculation

According to CFO Magazine, a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of financial analysis in 1919.  This was during a period when the chemical giant was known as being one of the most financially sophisticated, innovation corporations anywhere on the planet.

 In no small way, DuPont contributed to the modernization of the developed world by bringing new techniques, understandings, and insights into management.  As these were adapted throughout other sectors and industries, productivity increased along with standards of living for all Americans who had no idea they were collecting the proverbial dividends from these breakthroughs in the aftermath of the industrial revolution.

The DuPont model is so valuable because it doesn't just want to know what return on equity is.  Rather, it allows you to know what specific variables are causing the return on equity in the first place.  By measuring and highlighting those underlying realities, it becomes easier to target them, develop corporate policies to improve or modify that which can be optimized, and take control through intelligent, purposeful, decisive action.

Composition of Return on Equity Using the DuPont Model

There are three components in the calculation of return on equity when doing a DuPont model analysis.  These are:

By looking at each of these inputs individually, we can discover the source of a company's return on equity and compare it to its competitors.

 Let me walk you through each then we'll circle back and I'll show you how to do the DuPont model return on equity calculation.

The First Component: Net Profit Margin

The net profit margin is the after-tax profit a company generated for each dollar of revenue.  Net profit margins vary across industries, making it important to compare a potential investment against its competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales. This low-cost, high-volume approach has turned companies such as Wal-Mart and Nebraska Furniture Mart into veritable behemoths.

There are two ways to calculate net profit margin:

  1. Net Income ÷ Revenue
  2. Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue.

    Whichever calculation you prefer in your own analysis, think of the net profit margin as a safety cushion in the sense that, generally speaking, and with a few notable exceptions the lower the margin, the less room for error management has when dealing with things like inventory risks and payroll costs.  All else equal, a business generating 1% net profit margins has less room for execution failure than a business with 40% profit margins because small miscalculations or mistakes can be amplified in a way that leads to tremendous losses for shareholders.

    The Second Component: Asset Turnover

    The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:

    • Asset Turnover = Revenue ÷ Assets

    The asset turnover ratio tends to be inversely related to the net profit margin.  That is, the higher the net profit margin, the lower the asset turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which business is more attractive.

    A classic example comes from Wal-Mart Stores, Inc., which I mentioned a minute ago.  The company's founder, the late Sam Walton, often wrote and spoke about the insight that allowed him to build one of the largest fortunes in human history through his family holding company, Walton Enterprises, LLC.  He realized that he could make a lot more absolute profit by shoving enormous volumes of merchandise at relatively lower profit margins over his existing asset base than he could be extracting huge profit margins on individual sales.  This allowed him to take market share from competitors and grow exponentially along with some other tricks he used, such as leveraging sources of other people's money such as vendor financing.  He was amazed that the people competing against him could see how rich he was getting but couldn't bring themselves to switch to the discount model because they had become addicted to the idea of high-profit margins, focusing on those margins instead of total profits.

    By using a DuPont model return on equity breakdown, an investor could have seen how much higher Wal-Mart's return on shareholder equity was despite its noticeably lower profit margins.  This is one of the reasons it is so important for a small business owner, manager, executive, or other operators to clearly identify the business model they are going to use and stick to it.  Walton was worried that the Wal-Mart staff would someday become more concerned with improving profits through higher profit margins than sticking to his low-cost, high asset turnover method that was the secret behind the empire.  He knew that if that day ever came, it would be in danger of losing its competitive advantage. 

    The Third Component: The Equity Multiplier

    It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt.

    The equity multiplier is calculated as follows:

    • Equity Multiplier = Assets ÷ Shareholders’ Equity.

    This is not to say that debt is always bad.  In fact, debt is an important part of optimizing the capital structure of a firm to generate the best trade-off between return on capital, growth, and trade-offs as it pertains to equity dilution. Certain industries, such as regulated utilities and railroads, almost require debt as a matter of course.  Additionally, the corporate bonds that arise are an important backbone of the economy, providing a way for financial institutions such as property and casualty insurance companies, university endowments, and non-profits to put surplus assets to work generating interest income.  

    Rather, the problem arises when financial engineering goes too far.  It isn't unusual for a private equity fund to buy a business, load it down with debt, extract all of the equity, and leave it hobbled under enormous interest expense payments that threaten its solvency.  In certain cases, these businesses go public again through an IPO and are then forced to spend years using earnings and freshly raised capital to heal the damage.

    How to Calculate the DuPont Return on Equity

    To calculate the return on equity using the DuPont model, all you have to do is multiply the three components we've just discussed - net profit margin, asset turnover, and equity multiplier - together.  

    • Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).

    As you can see when you look at the sources of return on equity, figuring out how to pull those three levers is the key to growing your wealth.  In many cases, a poorly run but promising business can be taken over by a better manager who then is able to drive ROE through the roof and get very rich in the process.  In recent years, the food industry has been going through this as a result of several major buyouts.  The productivity gains under new management have been enormous, shaking up the sleepy ketchup, hot dog, coffee, and pudding markets.  

    As a matter of fact, a great many personal fortunes have been built by enterprising men and women who have searched for promising companies that were managed far below their theoretical DuPont return on equity figure.  

    Real-World Return on Equity Calculations 

    When I first wrote this piece on the DuPont model return on equity calculation more than a decade ago, I walked you through the calculation of return on equity using figures from PepsiCo's 2004 annual report. Since the principles involved are timeless, and I'm feeling a bit nostalgic about it, I'm going to keep it here for you.

    • Revenue: $29,261,000,000
    • Net Income: $4,212,000,000
    • Assets: $27,987,000,000
    • Shareholders’ Equity: $13,572,000,000

    Plug these numbers into the financial ratio formulas to get our components:

    Net Profit Margin: Net Income ($4,212,000,000) ÷ Revenue ($29,261,000,000) = 0.1439, or 14.39%
    Asset Turnover: Revenue ($29,261,000,000) ÷ Assets ($27,987,000,000) = 1.0455
    Equity Multiplier: Assets ($27,987,000,000) ÷ Shareholders’ Equity ($13,572,000,000) = 2.0621

    Finally, we multiply the three components together to calculate the return on equity:

    Return on Equity: (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%

    Analyzing Our DuPont ROE Results for PepsiCo

    A 31.02% return on equity was good in any industry back in 2004. Yet, if you were to have left out the equity multiplier to see how much PepsiCo would have earned had it been completely debt-free, you would have discovered that ROE dropped to 15.04%. In other words, for the year ended 2004, 15.04% of the return on equity was due to profit margins and sales, while 15.96% was due to returns earned on the debt at work in the business. If you found a company at a comparable valuation with the same return on equity yet a higher percentage arose from internally-generated sales, it would be more attractive. Compare PepsiCo to Coca-Cola on this basis and it becomes clear, especially after adjusted for the stock options that were then outstanding, that Coke was the stronger brand.  (If you are looking for a fun case study, I examined the investment performance of PepsiCo versus Coca-Cola over my lifetime on my personal blog.)

    Calculating the DuPont Return on Equity Model for Johnson & Johnson

    It's always good to provide multiple examples so let's take a look at Johnson & Johnson's most recently completed full fiscal year, 2015.  Pulling its Form 10-K filing, we find the necessary DuPont model return on equity components in the financial section statement:

    • Revenue: $70,074,000,000
    • Net Income: $15,409,000,000
    • Assets: $133,411,000,000
    • Shareholders' Equity: $71,150,000,000

    Putting these numbers into the financial ratio formulas, we can discover our DuPont analysis components:

    Net Profit Margin: Net Income ($15,409,000,000) ÷ Revenue ($70,074,000,000) = 0.2199, or 21.99%
    Asset Turnover
    : Revenue ($70,074,000,000) ÷ Assets ($133,411,000,000) = 0.5252
    Equity Multiplier: Assets ($133,411,000,000) ÷ Shareholders' Equity ($71,150,000,000) = 1.8751

    With that, we have the three components we need to calculate return on equity:

    Return on Equity: (0.2199) x (0.5252) x (1.8751) = 0.2166, or 21.66% 

    Analyzing Our DuPont ROE Results for Johnson & Johnson

    I've written about Johnson & Johnson's complex history in the past, explaining that it is really a holding company that has ownership stakes in 265 controlled subsidiaries spread across three different focus areas: consumer healthcare, medical devices, and pharmaceuticals.  Looking at its DuPont return on equity analysis, it is clear that it truly is one of the greatest businesses that has ever existed.  What is remarkable is that management has arranged the firm's structure so that debt plays a major role in the returns while the absolute debt level is extremely low relative to cash flow.  In fact, Johnson & Johnson's interest coverage ratio is so good, and its cash flows so secure, that following the 2008-2009 collapse that was the worst economic maelstrom since the Great Depression back in 1929-1933, it was one of only four companies with Triple A rated bonds.

    Specifically, the DuPont ROE analysis shows us that Johnson & Johnson's non-leveraged return on equity is 11.55% with the other 10.11% coming from the use of leverage; leverage that in no way poses any threat to the safety or stability of the enterprise.  It could even be said that a prudent investor might consider acquiring shares of Johnson & Johnson to hold for life and pass on to children and grandchildren using the stepped up basis loophole, any time it is reasonable priced or undervalued.

    Final Thoughts on Using the DuPont Return on Equity Method

    When you learn to internalize the DuPont return on equity method, you start to see all businesses by their underlying components.  It's somewhat like a watchmaker peering past the bezel and into the complications that reside below the bejeweled casing.  You walk into a retail store and truly see the economic reality of the enterprise, not just store shelves and merchandise.  You pass a manufacturing plant and can piece together how it is producing wealth for owners compared to other manufacturing plants.  

    Despite its seemingly mundane mathematical premise, changing your mindset to view the world through the eyes of the DuPont model is a bit like giving yourself a superpower.  Apply the insights you garner wisely and you can make a lot of money or, just as importantly, avoid disasters that could have otherwise harmed your portfolio.  You can even help offset a corporate crisis such as the one that the family-owned Barilla suffered after it offended millions of people.  To try and avoid losing market share, it decided to modify its DuPont return on equity variables by lowering profit margins and driving up volumes until the storm passed in an emergency attempt to stabilize as its products were pulled from shelves and boycotts erupted throughout the United States and Europe.  No matter how you feel about them, that was a very smart way to behave under the circumstances, even if those circumstances were entirely due to the stupidity and bigotry of the CEO.