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DuPont Analysis: Dissecting the Return on Capital

"In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the
best businesses by far for owners continue to be those that have high returns on capital and that
require little incremental investment to grow. We are fortunate to own a number of such businesses,
and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing
amounts of cash, we are today quite willing to enter businesses that regularly require large capital
expenditures. We expect only that these businesses have reasonable expectations of earning decent
returns on the incremental sums they invest. If our expectations are met – and we believe that they
will be – Berkshire's ever-growing collection of good to great businesses should produce aboveaverage, though certainly not spectacular, returns in the decades ahead."
Warren Buffet, Letter to shareholders, 2009.

Investors use return on equity (ROE) to measure the earnings a company generates from its assets.
With it, you can determine whether a firm is a profit-creator or a profit-burner and management’s
profit-generating efficiency. Why is this important to investors? Companies that are good at coaxing
profits from their operations tend to have competitive advantages, which can translate into superior
investment returns. In its simplest form, return on equity is calculated as follows:
ROE = Net income / Shareholders’ equity
Shareholders’ equity is also called book value, which is the difference between total assets and total
liabilities. It may be more accurate to use the average equity at the beginning and end of the year for
the above computation. It is obvious that the higher a company’s return on equity, the better
management is at employing investors’ capital to generate profits.
The above formula indicates that the management may generate high net income, but it is not
necessary that it is efficient if it is utilizing high amount of equity, and vice versa. If a company generate

the manufacturer's ROA is smaller.I. is another sign the company has a competitive moat. What's important to them is not how efficiently the company uses its money. the basic formula for ROE. relying on the formula above to derive return on equity tells an incomplete story about a company. For example. However. it is a good idea to examine the drivers of ROE. for instance. according to Morningstar. Company borrowing affects the equity and the ROE but it doesn't alter the assets. ROA provides a more reliable metric. this system has become known as the DuPont model. Three-Step DuPont Model The three-step DuPont model is calculated as follows: ROE = NI / E = Net profit margin (NPM) × asset turnover (AT) × equity multiplier (EM) Where: Net profit margin = net income ÷ sales = NI / Sales Asset turnover = sales ÷ average total assets = Sales / TA. but that doesn't demonstrate than it is run less well than low-asset businesses. du Pont Nemours and Company came up with a system to deconstruct ROE. Note that the first two terms is actually the Return on Assets ROA = NI / TA = NI / S x S / TA Because it uses assets rather than equity. It's not as easy to distort ROA as it is ROE. ROA tells you how well the companies you're looking at manage their assets to make money. With more assets. E. A manufacturer typically has more physical assets than an ad agency or software firm. but many investors are less interested in ROA. An ROA of 10 percent. Over the years. or an ROE of 5%. it is not good. but how good a return it gives the shareholders . What can lead you astray is using ROA to compare businesses in different fields. In order to do that. If its debt load becomes excessive. or an ROE of 33%. the management is doing a great job. it may force the company into bankruptcy.RM100m of profit with RM2 billion from shareholder’s fund. a company can boost its ROE by taking on additional debt. and Equity multiplier = average total assets ÷ average shareholders’ equity or TA / E Or ROE = NI/ E = NI / Sales * Sales / TA * TA / E A little algebra shows that the above formula is reduced to ROE = NI / E. whereas a company earns RM10 with only RM30 m from money foot in by shareholders. As a result.

we would like to see a company boosting its ROE by increasing its net margin or its asset turnover. The majority of high-margin companies also tend to have low asset turnover.The three-step DuPont model. historically. In industries where there are few barriers to entry. certain ranges can be expected across industries. When producing such “commodity” products or services. Companies are said to have wide moats if they are able to prevent new competition from entering or are in a position to lower their prices in response to new competition and make up for lower margins with higher volume. in effect. and. management must price a product to be as profitable as possible while still generating stable sales growth. Net margins vary from company to company. Asset Turnover Asset turnover measures how much sales a company generates from each dollar of assets. a company can boost shareholder returns without necessarily increasing profit margins. all the sales volume in the world is useless if a company cannot turn a profit. However. Companies with high profit margins indicate that they have a highly proprietary product or service that carries with it a price premium. all else being equal. as they rely on high sales volume to generate profits. as similar business constraints exist in each distinct industry. Therefore. Net Profit Margin The net profit margin (or net margin) of a company reflects management’s pricing strategy by showing how much earnings they can generate from a single dollar of assets. . Profit margins are also an expression of the amount of competition a company faces—the more competitive the industry. This is because a firm can only do a certain amount of business without incurring additional costs that would adversely impact profit margins. high profit margins are quickly eroded as new competitors enter the marketplace. It allows us to gauge management’s effectiveness at using assets to drive sales. Ideally. it is important to compare the ROEs and other financial ratios of companies in similar lines of business. Companies in a monopolistic position or those that are part of an oligopoly (only a few main competitors) tend to have higher profit margins. captures management’s effectiveness at generating profits (net profit margin). companies must compete based on price. The companies in these types of industries tend to have very low profit margins. managing assets (asset turnover) and finding an optimal amount of leverage (equity multiplier). By improving its asset management policies. In contrast. the lower the profit margins for the companies in the industry. Therefore. there are industries where there is little to differentiate the product of one company from another. Companies must be able to price their products and services in such a way as to drive volume. On the flip side. low-margin firms tend to have high asset turnover.

7% is much more superior compared to that of Kimlun of 12. A higher equity multiplier indicates higher financial leverage.182 915249 404262 *=NI/Revenue *=Revenue/Total assets *=Total assets/Total equity 26. If a company is already sufficiently levered. NI Total assets Total equity 1.53 1. Net Income margin. Pintaras and Kimlun using their financial statement of 2014.25 4. ROA Return on Equity.2%.Equity Multiplier The final component of the three-step DuPont Model is the equity multiplier. It is clear from the table above that Pintaras has achieved a higher ROA of 14. Few construction companies have their net profit margin in double digits. Table 1: Dissection of ROE for Pintaras and Kimlun Company Revenue Net Income.33.33 2. Assets Turnover AT 3. which means the company is relying more on debt to finance its assets.219. It is also clear that the next measurement of efficiency.238 383522 307256 Kimlun 1. not to say anywhere close to that of Pintaras. didn’t manage to produce good ROA due to its thin net profit margin of just 4%. It helps us examine how a firm uses debt to finance its assets. Table 1 below shows how the ROE of Pintaras was achieved versus that of Kimlun.4% 12. The first measurement for efficiency in managing the assets of the company is the Return on Assets. The higher ROE of Pintaras was achieved again with a very high net profit margin of 26. Equity Multiplier EM 2014 #000 #000 #000 #000 Pintaras 201907 54. the most desirable way to achieve a higher ROE.4% of Kimlun. ROE Note: I could have used the average equity instead. which is a measure of financial leverage. NIM 2. ROE of Pintaras of 17. DuPont Analysis of Pintaras Vs Kimlun Let us examine the dissection of ROE of two companies which are both in the construction industry. Generally a ROA of more than 10% in the construction industry shows the management’s ability to manage its assets efficiently. taking on additional debt increases the risks of not being able to fulfil its obligations to creditors and going bankrupt. . The higher ROA for Pintaras is generated with its high net margin of work of 26.9%.7% 5.714 49.0% 1.9%. and ROA of less than 5% is poor. The ratio ROA gives an idea of how efficient management is at using its assets to generate profit.9% 0.1% than the 5. meaning it has a lot more work to do.2% Return on Assets. with a much higher asset turnover of 1.1% 17. A company can boost its ROE by raising its equity multiplier (increasing the amount of debt it carries).26 *1*2 *=1*2*3 14. Kimlun.

further increases its financial leverage. i. The DuPont Analysis of dissecting the ROE of Pintaras and Kimlun shows that Pintaras has a higher ROE of 17. was only able to achieve a ROE of just 12. despite having higher asset turnover and financial leverage. and hence a better company.44 time its equity. pale in comparison with the RM1220 m of Kimlun.7%. and hence its ROE. retained earnings and much more.2%. It can even recapitalizes its balance sheet with some debts by borrowing some money from the bank if requires. DuPont Analysis of ROE is just a way to determine which company in the same industry has a better management efficiency. revenue. In order to increase its financial leverage and improves its ROE. Always bear in mind that a better company is not necessary a better investment.05 per share to the shareholders.e.53. Pintaras’s annual turnover of RM202 m is however.Furthermore the higher ROE was also achieved with much lower equity multiplier or financial leverage of just 1. much lower than that of Pintaras and one even below its cost of equity.26 of Kimlun which has total debts 0. . Kimlun. and hence higher debt and more risky as a result. one thing Pintaras can do is to distribute all its cash and cash equivalent of RM1. ROE gives investors a glimpse at the management’s efficiency in making profits in utilizing its assets. Pintaras is a debt free company. It was also achieved with the more desirable mean.33 times is more than two and a half times that of Pintaras of 0. The asset turnover of Kimlun at 1. We will have to look at its market valuation which is in the later part of the course. ROE gives insights on the company’s margins. In contrary. However. and dissecting ROE. the high profit margin coupled with low financial leverage.25 compared to relatively high financial leverage of 2. the ROE of Pintaras is still way above that of Kimlun. as special dividend! This will have minimal effect on its healthy balance sheet. Hence it hardly leverages itself to do business. In fact it has too much cash in its balance sheet. tells investors so much more than a simple revenue and EPS number. this is the prerogative of the management who should know better of what is best course of action for the company. not just simply how much is its revenue or how much it earned. one which is higher than its cost of equity. Conclusions It can be seen from the above example that ROE.