How to incorporate the Dupont analysis while researching stocks?
As investors in the stock markets, it is important to find high-quality along with fairly valued companies to invest our capital. The rationale behind this is simple. Our aim in the markets is to always preserve our capital first and then produce profits.
There are several robust tools that investors use during their stock analysis.
In this post, we will make an attempt to share one such powerful framework to assess the quality of stocks that we target for our portfolio -The Dupont Analysis.
The topics we shall aim to cover are as follows-
- What is the DuPont Analysis? Who made it?
- The technical background of the DuPont Analysis.
- Real world DuPont Analysis of Eicher Motors
The post should be an easy read and we hope our readers find this to be of great value to their time. Feel free to reach out to us or post comments in case of any doubts or clarifications.
1. What is the DuPont Analysis? Who made it?
DuPont analysis was created around the 1920s by Donaldson Brown of Dupont Corporation. Initially, when Brown invented the framework it was used for assessing the managerial efficiency of the company before it got adopted by public market investors. His genius was breaking down the formula for Return on Equity (ROE) into its constituent parts to analyze the root cause of ROE.
2. The technical background of the DuPont Analysis
Breaking ROE into its constituents helps us investors analyze the company’s business model and how it manages to achieve excess returns for its shareholders.
Since most investors (including Warren Buffett) use ROE to judge the quality of a stock it would be of great use to us to understand how deep “Quality” actually runs within the business.
To understand how the analysis technique is used let’s start with the very basics. As most of us already know, Return on Equity (ROE) is calculated from the following formula –
Now, our friend Brown brown multiplied and divided the expression to get the following–
This expression is now also summarised as below-
But Brown did not stop there, he took this expression and went one step further. This time he multiplied and divided the expression with Total Assets to give us the DuPont formula-
Which is again summarised as,
From the last expression, it becomes clear that ROE is not merely a ratio (as per the formula we started with) but a framework to understand the business and capital position of the company as a whole.
Valuable insights can be derived from knowing which of the attributes drives the rise or deterioration of ROE over a period of time.
It can also be used to compare companies with their peer sets to get a deeper understanding of the differences in the business models between the companies.
3. Real world DuPont Analysis on Eicher Motors:
Let us perform the DuPont analysis on Eicher motors for the period 2014-2018.
The summary table and the evolution of the three attributes from the analysis is as given below.
|Financial Ratio||2014||2015||2016||2017||2018||Net Effect|
|Net Profit Margin||5.8||7.0||21.9||23.7||21.9||Increased|
From the table, we can see that the company has improved its ROE from 19.2% to 27.9% in 5 reporting periods.
We can also see that the company decreased its leverage and asset turnover but this drop was offset by close to 3.7 times rise in the net profit margins.
Further, notice that the leverage ratio has been stable since 2016 while asset turnover has seen a drop in 2015-2016 and then moderate decreases from 2016-2018.
This analysis can now set the foundation for further analysis, the questions raised from the above figures could be as below ( this may not be very exhaustive but may give an idea as to how the framework is used)-
- What is causing the decrease in asset turnovers? Is it because of rising inventory? A fall in efficiency? Or perhaps a decrease in capacity utilisations at manufacturing facilities?
- Is the Net Profit Margins led by rise in prices or decrease in costs of goods sold?
- What caused the spike in net profits and the corresponding drop in asset turnover?
Answering the above questions in additions to questions generated by assessing the financial statements could help the investors analyze Eicher Motors in greater depth.
Since ROE is used as a measure of the quality of management by many investors, the incorporation of DuPont Analysis could help quell any illusions developed by using ROE at face value.
According to DuPont formula, ROE is a function of net profit margins, asset turnover, and the leverage ratios. A rise or dip in ROE could be because of a corresponding rise/fall in any of these metrics and hence a high ROE doesn’t always indicates a better performance.
Our readers are advised to use DuPont Analysis along with the other stock evaluation frameworks and not to solely depend on data provided by the financial websites.
That’s all for this post. I hope it was helpful to you. Happy Investing!!