Dupont Analysis Article 2 DuPont Analysis The Decomposition of ROE

DuPont Analysis Article #2—CFA Approach
DuPont Analysis—The Decomposition of ROE

ROE measures the return a company generates on its equity capital. To understand what drives a company’s
ROE, a useful technique is to decompose ROE into its component parts. Originally, this method was developed
by the DuPont Corporation in the 1920’s. Decomposing ROE involves expressing the basic ratio (i.e., net
income divided by average shareholders’ equity) as the product of component ratios. Because each of these
component ratios is an indicator of a distinct aspect of a company’s performance that affects ROE, the
decomposition allows us to evaluate how these different aspects of performance affected the company’s
profitability as measured by ROE.
Decomposing ROE is useful in determining the reasons for changes in ROE over time for a given company and
for differences in ROE for different companies in a given time period. The information gained can also be used
by management to determine which areas they should focus on to improve ROE. This decomposition will also
show why a company's overall profitability, measured by ROE, is a function of its efficiency, operating
profitability, taxes, and use of financial leverage. DuPont analysis shows the relationship between the various
categories of ratios discussed in this reading and how they all influence the return to the investment of the
owners. Analysts have developed several different methods of decomposing ROE. The two methods presented
here are the most commonly used and found in popular research databases, such as Bloomberg.
Three-Way Decomposition
Return on equity is calculated as:
Net Income
ROE=
Average Shareholder s ' Equity
The decomposition of ROE makes use of simple algebra and illustrates the relationship between ROE and ROA.
Expressing ROE as a product of only two of its components, we can write:
Net Income Net Income Average Total Assets

ROE= = x
Aveage Shareholder Equity Average Total Assets Average Shareholder s ' Equity
which can be interpreted as

ROE=ROA x Financial Leverage
In other words, ROE is a function of a company's ROA and its use of financial leverage ("leverage" for short, in
this discussion). A company can improve its ROE by improving ROA or making more effective use of leverage.
Consistent with the definition given earlier, leverage is measured as average total assets divided by average
shareholders' equity. If a company had no leverage (no liabilities), its leverage ratio would equal 1.0 and ROE
would exactly equal ROA. As a company takes on liabilities, its leverage increases. As long as a company is able
to borrow at a rate lower than the marginal rate it can earn investing the borrowed money in its business, the
company is making an effective use of leverage and ROE would increase as leverage increases. If a company's
borrowing cost exceeds the marginal rate it can earn on investing in the business, ROE would decline as leverage
increased because the effect of borrowing would be to depress ROA.
Assume you are an investment analyst and you obtain the information in Table 1 about a certain company called
Anson Industries. You can examine the trend in ROE and determine whether the increase from an ROE of -0.62
percent in FY2 to 5.92 percent in FY5 is a function of ROA or the use of financial leverage:
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Table 1—Anson Industries
ROE ROA Financial Leverage

FY5 5.92% = 3.70% x 1.60
FY4 1.66% = 1.05% x 1.58
FY3 1.62% = 1.05% x 1.54
FY2 -0.62% = -0.39% x 1.60
Note that over the four-year period, the company's leverage factor was relatively stable. Thus, the primary reason
for the increase in ROE is the increase in profitability measured by ROA—in other words, a more efficient use of
the assets in order to generate profitability.
Just as ROE can be decomposed, the individual components such as ROA can be decomposed. Further
decomposing ROA, we can express ROE as a product of three component ratios:
Net Income Net Income Revenue Average Total Assets

= x x
'
Average Shareholder s Equity Revenue Average Total Assets Average Shareholder s ' Equity
which can be interpreted as:

ROE=Net Profit Margin x Total Asset Turnover x Financial Leverage
The first term on the right-hand side of this equation is the net profit margin, an indicator of profitability: how
much income a company derives per one monetary unit (e.g., euro or dollar) of sales. The second term on the
right is the asset turnover ratio, an indicator of efficiency: how much revenue a company generates per one
money unit of assets. Note that ROA is decomposed into these two components: net profit margin and total asset
turnover. A company's ROA is a function of profitability (net profit margin) and efficiency (total asset turnover).
The third term on the right-hand side of Equation 1b is a measure of financial leverage, an indicator of solvency:
the total amount of a company's assets relative to its equity capital. This decomposition illustrates that a
company's ROE is a function of its net profit margin, its efficiency, and its leverage. Again, using the data for
Anson Industries, the analyst can evaluate in more detail the reasons behind the trend in ROE:
Table 2—Anson Industries
Total Asset Financial

ROE Net Profit Margin
Turnover Leverage
FY5 5.92% = 3.33% x 1.11 x 1.60
FY4 1.66% = 1.11% x 0.95 x 1.58
FY3 1.62% = 1.13% x 0.93 x 1.54
FY2 -0.62% = -0.47% x 0.84 x 1.60
This further decomposition confirms that increases in profitability (measured here as net profit margin) are
indeed an important contributor to the increase in ROE over the four-year period. However, Anson's asset
turnover has also increased steadily. The increase in ROE is, therefore, a function of improving profitability and
2
improving efficiency. Decomposing ROE in this manner can also be used to compare the ROEs of peer
companies, as follows.
Table 3—A Comparison of Two Companies—Anson Industries and Clarence Corporation

FY2 FY3 FY4 FY5
Anson Industries
Inventory Turnover 187.64 147.82 89.09 76.69
DOH (Days on Hand) 1.95 2.47 4.10 4.76
Receivables Turnover 7.56 11.14 9.33 10.75
DSO (Days Sales Outstanding) 48.29 32.77 39.13 33.95
Accounts Payable Turnover 4.22 4.84 4.36 4.62
Days Payable 86.56 75.49 83.77 78.97
Cash from Operations/Total Liabilities 8.81% 4.04% 11.15% 31.41%
ROE -0.62% 1.62% 1.66% 5.92%
ROA -0.39% 1.05% 1.05% 3.70%
Net Profit Margin (Net Income/Revenue) -0.47% 1.13% 1.11% 3.33%
Total Asset Turnover (Revenue/Average 0.84 0.93% 0.95 1.11
Assets)
Financial Leverage (Average Assets/Average 1.60 1.54 1.58 1.60
Equity)
Clarence Corporation FY2 FY3 FY4 FY5

Inventory Turnover 14.84 7.52 9.08 9.19
DOH 24.59 48.51 40.20 39.73
Receivables Turnover 5.16 6.09 7.01 8.35
DSO 70.76 59.92 52.03 43.73
Accounts Payable Turnover 6.52 7.66 6.61 6.47
Days Payable 56.00 47.64 55.22 56.44
Cash from Operations/Total Liabilities 11.79% 15.80% 16.39% 13.19%
ROE -6.75% -3.63% 6.82% 9.28%
ROA -3.23% -1.76% 3.48% 4.64%
Net Profit Margin (Net Income/Revenue) -2.34% -1.60% 3.48% 4.38%
Total Asset Turnover (Revenue/Average 1.38 1.10 1.00 1.06
Assets)
Financial Leverage (Average Assets/Average 2.09 2.06 1.96 2.00
Equity)
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Question 1: Referring to the data for Anson Industries and Clarence Corporation above, which of the
following choices best describes reasonable conclusions an analyst might make about the two companies’
efficiency?
A. Over the past four years, Anson has shown greater improvement in efficiency than Clarence, as
indicated by its total asset turnover ratio increasing from 0.84 to 1.11.
B. In FY5, Anson’s DOH of only 4.76 indicated that it was less efficient at inventory management
than Clarence, which had DOH of 39.73.
C. In FY5, Clarence’s receivables turnover of 8.35 times indicated that it was more efficient at
receivables management than Anson, which had receivables turnover of 10.75.
Question 2: Referring to the data for Anson Industries and Clarence Corporation above, which of the
following choices best describes reasonable conclusions an analyst might make about the companies'
ROE?
A. Anson's inventory turnover of 76.69 indicates it is more profitable than Clarence.
B. The main driver of Clarence's superior ROE in FY5 is its more efficient use of assets.
C. The main drivers of Clarence's superior ROE in FY5 are its greater use of debt financing and
higher net profit margin.
Solutions:
Question #1: A is the correct answer. Over the past four years, Anson has shown greater improvement in
efficiency than Clarence, as indicated by its total asset turnover ratio increasing from 0.84 to 1.11. Ove the
same period, Clarence’s total asset turnover ratio has declined from 1.38 to 1.06. Choices B and C are incorrect
because DOH and receivables turnover are misinterpreted.
Question #2: C is correct. The main driver of Clarence's superior ROE (9.28 percent compared with only 5.92
percent for Anson) in FY5 is its greater use of debt financing (leverage of 2.00 compared with Anson's leverage
of 1.60) and higher net profit margin (4.38 percent compared with only 3.33 percent for Anson). A is incorrect
because inventory turnover is not a direct indicator of profitability. An increase in inventory turnover may
indicate more efficient use of inventory which in turn could affect profitability; however, an increase in inventory
turnover would also be observed if a company was selling more goods even if it was not selling those goods at a
4
profit. B is incorrect because Clarence has less efficient use of assets than Anson, indicated by turnover of 1.06
for Clarence compared with Anson's turnover of 1.11.
Five-Way Decomposition
To separate the effects of taxes and interest, we can further decompose the net profit margin and write:
Net Income
'
=¿
Average Shareholder s Equity
Net Income EBT EBIT Revenue Average Total Assets
x x x x
EBT EBIT Revenue Average Total Assets Average Shareholder s' Equity
which can be interpreted as

ROE=¿
Tax Burden x Interest Burden x Operating Margin x Total Asset Turnover x Financial Leverge
This five-way decomposition is the one found in financial databases such as Bloomberg (FA, click on 5) Ratios,
click on 17) DuPont Analysis). The first term on the right-hand side of this equation measures the effect of taxes
on ROE. Essentially, it reflects one minus the average tax rate, or how much of a company's pretax profits it gets
to keep, This can be expressed in decimal or percentage form. So, a 30 percent tax rate would yield a factor of
0.70 or 70 percent. A higher value for the tax burden implies that the company can keep a higher percentage of
its pretax profits, indicating a lower tax rate. A decrease in the tax burden ratio implies the opposite (i.e., a
higher tax rate leaving the company with less of its pretax profits).
The second term on the right-hand side captures the effect of interest on ROE. Higher borrowing costs reduce
ROE. Some analysts prefer to use operating income instead of EBIT for this term and the following term. Either
operating income or EBIT is acceptable as long as it is applied consistently. In such a case, the second term
would measure both the effect of interest expense and non-operating income on ROE.
The third term on the right-hand side captures the effect of operating margin (sometimes operating income is
used in the numerator or another analyst will use EBIT there) on ROE. In either case, this term primarily
measures the effect of operating profitability on ROE.
The fourth term on the right-hand side is again the total asset turnover ratio, an indicator of the overall efficiency
of the company (i.e., how much revenue it generates per unit of total assets). And finally, the fifth term on the
right-hand side is the financial leverage ratio described above—the total amount of a company's assets relative to
its equity capital.
This decomposition expresses a company's ROE as a function of its tax rate, interest burden, operating
profitability, efficiency, and financial leverage. An analyst can use this framework to determine what factors are
driving a company's ROE. The decomposition of ROE can also be useful in forecasting ROE based upon
expected efficiency, profitability, financing activities, and tax rates. The relationship of the individual factors,
such as ROA to the overall ROE, can also be expressed in the form of an ROE tree to study the contribution of
each of the five factors, as shown below for Anson Industries. 1 Table 2 shows that Anson's ROE of 5.92 percent
in FY5 can be decomposed into ROA of 3.70 percent and leverage of 1.60. ROA can further be decomposed into
a net profit margin of 3.33 percent and total asset turnover of 1.11. Net profit margin can be decomposed into a
tax burden of 0.70 (an average tax rate of 30 percent), an interest burden of 0.90, and an EBIT margin of 5.29
percent. Overall ROE is decomposed into five components.
1 Note that a breakdown of net profit margin was not provided in Table 2, but is added here.
5
Return on Equity
= 5.92%
Return on Assets Financial Leverage
= 3.7% = 1.60
Net Profit Margin Total Asset Turnover
= 3.33% = 1.11
Tax Burden Interest Burden Operating Margin
= 0.70 = 0.90 = 5.29%
The next example demonstrates how the five-component decomposition can be used to determine reasons
behind the trend in a company’s ROE
An analyst examining Royal Dutch Shell PLC (RDSA US Equity) wishes to understand the factors driving the
trend in ROE over a recent four-year period. The analyst obtains and calculates the following 2006-2009 data
about Shell from Bloomberg:
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Table 4—Royal Dutch Shell PLC Five-Way Decomposition DuPont Analysis
2006 2007 2008 2009
1
ROE 25.88% 25.37% 18.95% 10.67%
Tax Burden 57.01% 61.95% 51.71% 59.55%
Interest Burden 97.49% 97.86% 97.735 97.49%
Operating Margin 14.36% 14.53% 11.34% 7.75%
Asset Turnover 1.4 1.41 1.66 0.97
Financial Leverage 2.31 2.20 2.20 2.18
1
Since 2009, Bloomberg data experts have provided non-GAAP adjustments to the income
statement to remove the impact of one-time and other abnormal charges. Thus the
DuPont Analysis on Bloomberg includes an “Adjustment Factor” to normalize net
income.
Question #3: Based on these ratios, what might an analyst conclude?
Solution:
The tax burden measure has varied, with no obvious trend. In the most recent year, 2009, taxes declined as a
percentage of pretax profit. (Because the tax burden reflects the relation of after-tax profits to pretax profits, the
increase from 51.71 percent in 2008 to 59.55 percent in 2009 indicates that taxes declined as a percentage of
pretax profits.) This decline in average tax rates could be a result of lower tax rates from new legislation or
revenue in a lower tax jurisdiction. The interest burden has remained fairly constant over the four-year period
indicating that the company maintains a fairly constant capital structure. Operating margin declined over the
period, indicating the company's operations were less profitable. This decline is generally consistent with
declines in oil prices in 2009 and declines in refining industry gross margins in 2008 and 2009. The company's
efficiency (asset turnover) decreased in 2009. The company's leverage remained fairly constant, consistent with
the constant interest burden. Overall, the trend in ROE (declining substantially over the recent years) resulted
from decreases in operating profits and a lower asset turnover. Additional research on the causes of these
changes is required in order to develop expectations about the company's future performance.
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DuPont Analysis Article #2—CFA Approach

DuPont Analysis—The Decomposition of ROE

Net Income Net Income Average Total Assets

which can be interpreted as

ROE ROA Financial Leverage

Net Income Net Income Revenue Average Total Assets

which can be interpreted as:

Table 2—Anson Industries

Total Asset Financial

Table 3—A Comparison of Two Companies—Anson Industries and Clarence Corporation

Clarence Corporation FY2 FY3 FY4 FY5

which can be interpreted as

Return on Assets Financial Leverage

Net Profit Margin Total Asset Turnover

Tax Burden Interest Burden Operating Margin

= 0.70 = 0.90 = 5.29%

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