The DuPont Model Return on Equity Formula for Beginners
More than perhaps any other single metric, an experienced investor or manager can look at a DuPont model return on equity (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 ascertaining how the individual components fit together to make it run.
What Is Return on Equity – ROE?
Simply stated, ROE reveals how much after-tax profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. 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 Model ROE 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, innovative 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 modern ideas and techniques 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:
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's walk through each, then we'll circle back on how to do the DuPont model return on equity calculation.
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 Walmart and Nebraska Furniture Mart into veritable behemoths.
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, 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 when dealing with things like inventory risks and payroll costs.
All else equal, a business generating 5 percent net profit margins has less room for execution failure than a business with 40 percent profit margins because small miscalculations or mistakes can be amplified in ways that could lead to tremendous losses for shareholders.
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 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. Along with other tricks he used, such as leveraging sources of other people's money using vendor financing, this allowed him to take market share from competitors and grow exponentially.
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 Walmart'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 Walmart 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 key to his empire's success. He knew that if that day ever came, Walmart would be in danger of losing its competitive advantage.
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, which is 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.
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.
Calculating 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 while getting 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.
Final Thoughts on Using the DuPont ROE 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. By walking into a retail store, you'll truly see the economic reality of the enterprise, not just store shelves, and merchandise. When passing a manufacturing plant, you 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 in 2013 after it offended millions of people. Its CEO made a comment that the company would never feature a same-sex-parent-family in a commercial. This comment was met with anger, outrage, and disappointment.
To try and stabilize its economic engine and avoid losing market share as its products were pulled from shelves while boycotts erupted throughout the United States and Europe, Barilla decided to modify its DuPont return on equity variables by lowering profit margins and driving up volumes until the storm passed. No matter how you feel about the company, that was a very smart way to behave under the circumstances, even if those circumstances were entirely due to the bigotry of the CEO.