The DuPont Model
Admittedly, it’s been ages since I finished business school. So many tools have been developed to perform traditional (and technical) financial analysis since then. A spreadsheet here, a “click” there, and reams of ratios magically appear. A treasure that has served me especially well as an investment banker, traditional banker, and throughout my (not so) illustrious career is the DuPont model. The DuPont model received just one page in my finance text book but deserves enshrinement in the financial analysis hall of fame.
Why is the DuPont Model an “oldie”? Because it was developed in 1912 by F. Donaldson Brown, an explosives salesman of the DuPont Corporation. Now over 100 years later, the DuPont model remains a powerful framework for analyzing fundamental performance, as it enables the decomposition of the drivers of return on equity. Most financial analyses focus on ROE (what an investor can expect, or target, by placing funds with the enterprise in question).
I recently posted a piece on EBITDA, and suggested that while adjusted EBITDA provides the basis for evaluating a company, that knowing the drivers of profitability will greatly assist a seller in obtaining maximum value. Enter the DuPont model, which breaks ROE into three distinct elements. This enables one to identify the source(s) of superior (or inferior) return on equity by comparison with companies in similar sectors. It should be noted that the DuPont model is less useful for industries such as investment banking in which the underlying elements are not as meaningful.
Let’s unpack the model:
ROE = Net Profit/Sales x Asset Turnover x Leverage
As you can see, ROE is determined by both income statement and balance sheet components. Rather than merely stating a company’s return on equity, one can identify (and model) what changes to profit margin, asset turnover and leverage will do to change ROE.
Profit Margin – obviously, a company’s profit margin significantly determines the entity’s ROE. The ability of a company to raise prices and control prices will greatly impact ROE. These are one of the reasons a company’s stock price quickly reacts to guidance on future pricing and expenses. Some industries (pharmaceuticals, fashion and beverage) derive a significant portion of their ROE from selling at relatively high margins.
High Turnover Industries – asset turnover varies greatly between sectors. Retailers and service sectors have low profit margins and relatively low leverage but garner high ROE from strong asset turnover. At the other end of the spectrum, utility and telecom companies are asset-intensive and therefore have low asset turnover.
Scott Tindall / Advisor
Financial Leverage – The debt-to-equity ratio is a basic metric used to assess a company’s financial position. As with profit margin and asset turn, differing industries have vastly different leverage profiles. The two primary reasons for differing leverage are the capital intensity of a sector (like petroleum refining) and whether the nature of the business makes carrying a high level of debt easier to manage (such as utilities. The two industries with the highest debt to equity ratios are utilities and financial services.
Analysis can lead to paralysis, and excessive data, KPIs and ratios are, well, excessive. The beauty, and power, of the DuPont Model is that is easily identifies the key drivers of a company’s ROE while revealing which of the primary ROE drivers are enhancing, or detracting, from the overall ratio. For an entrepreneur, keeping close tabs on these primary components will greatly enhance one’s understanding of which variables need to be addressed.