HOW TO USE DUPONT ANALYSIS FOR FINANCIAL

ANALYSIS: SOFT-DRINK EXAMPLE

There are three forms of the DuPont Analysis: a two part, a three part
and a five part analysis. The three forms are:

1. ROE
= (NI / Avg TA) x (Avg TA / Avg ShEq)
= ROA x Leverage

2. ROE
= (NI / Rev) x (Rev / Avg TA) x (Avg TA / Avg ShEq)
= Net Profit Margin x Asset Turnover x Leverage

3. ROE
= (NI / EBT) x (EBT / EBIT) x (EBIT / Rev) x (Rev / Avg TA) x
(Avg TA / Avg ShEq)
= Tax Burden x Interest Burden x EBIT Margin x Asset
Turnover x Leverage

Where:

ROE = Return on Equity

NI = Net Income
Avg TA = Average Total Assets
Avg ShEq = Average Shareholder Equity
Rev = Revenue
EBT = Earnings before Taxes
EBIT = Earnings before Interest and Taxes

I will be using the third form because I want to breakdown the ROE to
see where ROE is mainly coming from and to see the trends of those
individual parts.

So now that we have the formulas, let’s grab some data. Here is all the
data we need to do our analysis (I got these values from annual report
financial statements).
Now that we have the data we can run the DuPont Analysis for each
company.
Now that we have our tables we can begin our analysis. I will be looking
at four major parts for my analysis: 1) ROE, 2) EBIT (Profit) Margin, 3)
Asset Turnover, and 4) Leverage. There is also Tax Burden and Interest
Burden to look at if you would like, but I mainly focus on these four
figures. A complete analysis would include the other factors.

ROE

Coca-Cola has strong ROE over the 3-years. The range is between 27%
and 42%. This range is a bit large, but is on the high side and the low is
far above the 15% requirement.

PepsiCo has a strong ROE with a range between 30% and 41%. This is
very similar to Coca-Cola and would even be considered slightly better
because the minimum is higher and the range is narrower.

Cott Corporation has a down trending ROE. In 2009 it was strong at

26% (above the average). In 2010 it matched the S&P 500 30 year
average at around 12%. Then in 2011 it fell well below the average to 7%.
At this point I would be interested in Coca-Cola and PepsiCo and would
probably leave Cott Corporation alone.

EBIT (Profit) Margin

Coca-Cola has the strongest profit margin out of the three

companies. This can probably be attributed to one major reason. Coca-
Cola is probably the biggest brand in the soft-drink world. Because they
are such a strong brand, they can charge a premium for their
product. This premium leads to stronger profit margins. The profit
margin has slipped from past years so further analysis would be needed
to uncover the source of this slip.

PepsiCo is also strong in profit margin compared to its peers. It is not as

strong as Coca-Cola, but still produces strong numbers
consistently. There has also been a drop in profit margin in 2011, so
further analysis would be needed.

Cott is the weakest of all the companies. In 2011 the profit margin was
less than a third of that of PepsiCo and less than a fifth of Coca-
Cola’s. This is because Cott is a low cost producer. You don’t see
advertisements for Cott Cola, there are no famous sports stars or movie
stars selling the product. Cott has basically made their product a
“commodity” and cannot charge a premium for it.

It looks like profit margins have fell for all three companies over the past
three years. It seems to be more an industry or market effect than an
individual company effect. This would require more analysis to find out
what has caused this drop in the soft-drink industry.

Asset Turnover

Coca-Cola has the lowest numbers here. This is a bit of a surprise

because Coke is a huge producer and should be able to take advantage of
economies of scale. Although their asset turnover is low, they still have a
high profit margin, so I would still consider looking into the company
(remember the rule of at least one of profit margin or asset turnover
should be high).

PepsiCo is interesting. The company has a fairly high asset turnover and
is quite consistent. There has been a drop from previous years, but the
numbers are still good. I would try and look into the reason why asset
turnover has dropped: a new product line that has failed? Consumers
drinking less soda? Users switching to Coca-Cola?

Cott Corporation has the highest asset turnover. It is not really a

surprise because they are a low cost provider. Their asset turnover is
more than double of that of Coca-Colas and over 50% greater than
PepsiCo. This makes up for their low profit margin, but an analysis and
comparison using profit margin, asset turnover, and some constant
variable would need to be used to find out which is most efficient
(profitable). But, looking at the ROEs, it looks like Cott’s strategy is not
as effective as Coke’s or Pepsi’s.

Leverage

Coca-Cola has the least amount of leverage of the three companies. This
would make them a more stable company if there was ever a big shock to
the soft-drink industry or the market as a whole. Their low leverage and
high ROE means that a good portion of returns are coming from organic
sales or effective management, not artificial leveraging. They have
steadily increased leverage which could be a concern.

PepsiCo has the highest leverage out of the three companies. This is an
aggressive strategy. PepsiCo would be more affected during a downturn,
but would gain more in a bull run. It would be interesting to see the
effects of their ROE without leverage compared to Coke’s. Would they
have a stronger or weaker ROE? PepsiCo has also been using more
leverage each year which could be a cause for concern.

For the size and profit margins of Cott, their leverage would be
considered high. Not only do they face the possibility of being hit hard in
a bad economy, but they do not have the brand power to keep
customers. One positive is that Cott hasn’t significantly changed their
leverage year-to-year.

It looks as though Coke and Pepsi have increased their leverage, but Cott
has stayed relatively the same. What I would speculate is that companies
are taking advantage of a low interest rate environment. The Interest
burdens haven’t greatly changed, but the amount of leverage has. The
big companies could be taking advantage of the fact that they can get
favorable rates on their loans. And I would guess Cott hasn’t followed
suit because they are not a big safe company, so it is harder for them to
get those favorable rates.

Now this is just speculation, it would take a lot more analysis to get to
the heart of the situation.

Final Analysis

It looks as though we have three different types of companies within the

same industry.

1. Coca-Cola: Differentiated product. Ability to charge a premium

producing higher profit margins. Because there is a premium on
the product, fewer units are sold (lower asset turnover).
2. PepsiCo: Middle of the Road. They have some brand power and
can add a premium to their product (good profit margin). Their
strategy still enables them to sell a decent amount of units (good
asset turnover).
3. Cott Corporation: Low cost producer. The strategy is to mainly
become a commodity. There is no real difference in their product
compared to competitors. This means that the company cannot
charge a premium (low profit margin). To compensate for this, the
company needs to use their assets more efficiently (high asset
turnover). One problem I see with Cott is that to be a successful
low cost provider, you need to have a large market share. Coke
and Pepsi are huge 800lbs gorillas in the soft-drink world. Cott
definitely has a smaller market share than either of these two
companies making their strategy hard to achieve.

My final thoughts would be to consider Coke and Pepsi and leave Cott for
another day. There may be potential in Cott, but I don’t see it from this
analysis.
Even though Coke and Pepsi are quite similar in product offering, you
can see that they have different strategies. PepsiCo looks strong; they
are a bit aggressive but are producing results. Coke, on the other hand,
seems to be more conservative and really focused on their “brand”. That
premium they offer seems to be their competitive advantage and it seems
as though management is focused on that.

For the long term I would probably tilt towards Coca-Cola (and yes, this
is probably influenced by my Warren Buffett obsession). The strategy of
developing a strong and lasting brand is working for Coke and they seem
to not be shying away from that strategy. PepsiCo seems to be more into
following trends and jumping on opportunities. This could make the
stock a great pick for active investors, but could also make it more
variable.

Obviously these are opinions and to choose a company would require a

lot more analysis using much more variables and comparisons. You
would also have to consider price. Just because Coke is a good company
doesn’t mean they are priced favorably.

This brings us to the end of our DuPont Analysis tutorial. I hope it has
helped you see the usefulness of DuPont Analysis and how you can break
down a company’s ROE, find out where returns are derived from, and get
a picture of the company’s strategy.

As always, comment below and let us know what you think. Do you use
the DuPont Analysis in a different fashion? Is ROE useless in your
mind? Does Warren Buffett get his hair cut at First Choice
haircutters? Leave a comment below!