What Is the DuPont Model Return on Equity, or ROE, Formula?
How to Calculate the DuPont Model ROE
The DuPont Model Return on Equity (ROE) Formula is a framework for gaining insight into the capital structure of a firm, the quality of the business, and the levers that are driving the return on invested capital.
Learn how the DuPont ROE is calculated and how its components work to produce the results.
What Is the DuPont Model Return on Equity, or ROE, Formula?
The DuPont Model Return on Equity (ROE) Formula allows experienced investors to 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—perhaps more so than with any other single metric.
The DuPont model is so valuable because it doesn't just want to know what the return on equity is. Instead, it explores the specific variables that are causing the ROE 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.
A finance executive at the DuPont Company in Wilmington, Del., created the DuPont system of financial analysis in 1919.
In general, ROE reveals how much after-tax profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. ROE is one of the most important indicators of a firm’s profitability and potential growth.
Companies that boast a high ROE 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 ROE analysis can help—is that two companies can have the same ROE, 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.
How Do You Calculate ROE?
There are three components in the calculation of ROE when doing a DuPont model analysis:
By looking at each of these inputs individually, we can discover the source of a company's ROE and compare it to its competitors. By multiplying the three components together, we can calculate the DuPont model ROE.
As you can see when you look at the sources of ROE, 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 while getting very rich in the process.
When calculating the DuPont model ROE, it's important to understand the three components involved in the formula.
What Is the 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.
There are two ways to calculate net profit margin:
Net Income ÷ Revenue
Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue
Whichever calculation you prefer in your own analysis, you can think of the net profit margin as a safety cushion in a sense. Generally speaking—though there are some exceptions—the lower the margin, the less room for error management when dealing with things like inventory risks and payroll costs.
With everything else being equal, a business generating 5% net profit margins has less room for execution failure than a business with 40% profit margins. This is because small miscalculations or mistakes can be amplified in ways that could lead to tremendous losses for shareholders.
What Is 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: 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 great example of this comes from Walmart. The late Sam Walton, the founder of Walmart, 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 significantly more absolute profit by shoving enormous volumes of merchandise at relatively lower profit margins over his existing asset base than he could by extracting huge profit margins on fewer individual sales. This allowed him to take market share from competitors and grow exponentially.
Walton was amazed that the people competing against him could see how rich he was getting, but they 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 ROE breakdown, an investor could have seen how much higher Walmart's return on shareholder equity was despite its noticeably lower profit margins.
What Is the Equity Multiplier?
It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its ROE. The equity multiplier, which is a measure of financial leverage, allows the investor to see what portion of the ROE 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.
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 nonprofits, to put surplus assets to work generating interest income.
A problem with debt finances can arise when financial engineering goes too far. It isn't unusual for a private equity fund to buy a business, bury it with debt, extract all of its 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 use earnings and freshly raised capital to heal the damage, sometimes lasting years at a time.
- The DuPont Model Return on Equity (ROE) Formula allows experienced investors to 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.
- The DuPont ROE is calculated by multiplying the net profit margin, asset ratio, and equity multiplier together.
- This model is so valuable because it doesn't just want to know what return on equity is. Instead, it explores the specific variables that are causing the return on equity in the first place.