Well, I'm Professor Brian Bushee,

welcome back. In this video, we're gonna start out

ration analysis of wolf junction with something called the DuPont Analysis. The
DuPont Analysis is a common method for trying to trying to identify a company's
competitive advantages or disadvantages. The analysis will break down this
ratio called return on equity or ROE, which is a measure of how much return the
company generates for its shareholders. It'll break it down into three
components: profitability, the efficiency with which managers
are running the company, and leverage, or how much debt the company has taken on.
By breaking our way down
into those three components, we can see where a company is doing
better, or not as good as its competition. Let's get started. The analysis
framework that
we will be using is called the DuPont Ratio Analysis Framework. >> Eh, is this
named after
Eleuthere Irenee du Pont? >> Well the DuPont formula's named
after the DuPont Chemical Company, where it was developed
in the 19th Century. And I guess the DuPont Chemical Company is
named after the guy you mentioned before. So, indirectly it is named after that
guy. But since you interrupted me, let me try to preempt a question that may
come up as we go through these slides. So in these ratios, were gonna compare
income statement numbers like net income to balance sheet number like assets. The
probably run into is,
net income happened over an entire year where is a balance sheet number
like asset is at a point in time. So what you'll notice is were gonna
take averages of the beginning and ending balances of all of
the balance sheet accounts to approximate the level during the year. So you'll see
an income statement number
for the period, divided by the average of the balance sheet number using the
balance
at the beginning and ending of the period. The framework starts with
the ratio Return on Equity or ROE. This is defined as net income,
divided by average shareholders equity. And it tells us how much return the
company generates for it's shareholders. In other words for
every dollar of shareholder investment. How much return or net income
do the management team generate? There's two drivers of ROE. Return on Assets or
ROA and
Financial Leverage. Return on Assets is defined
as Net Income / Avg. Total Assets. It's answering the question how
effectively do the managers use their resources or
assets to generate profits. So it's a measure of
operating performance. For each dollar of assets, how much
net income does the company generate? The other component is Financial Leverage.
Which is Avg. Total Assets / Avg. Shareholders Equity. And this tells us how much
debt does the company use to try to increase its total assets. So for
every dollar of shareholder investment, shareholders equity,
how many assets are they able to buy? You're able to buy more than
a dollar assets if you take on debt. We're really gonna focus
on the return on assets, cuz we wanna understand the operating
performance of the company. And there's two drivers of ROA. There's Return on Sales
or
ROS, and Asset Turnover. Return on Sales is
a measure of Profitability. It's defined as Net Income / Sales. It answers the
question of how
much profit does the company earn on each dollar of sales. Asset Turnover is a
measure of Efficiency. It's Sales / Avg. Total Assets. It's answering the question
how much
sales does the company generate? Using it's available assets, so for every dollar
of assets,
how much sales can it generate. Now if we bring back down Leverage, we can see the
DuPont innovation was
to notice that ROE, return on equity is equal to Net Income / Sales
x Sales/Assets x Assets/Equity. In other words ROE equals
Profitability x Efficiency x Leverage. This decomposition will let us take a look
at whether a company's advantages or disadvantages in their ROE is
driven by their Profitability, their Efficiency, or their Leverage. >> My sister is
a long-short
hedge fund guru and she says you always have to
use de-levered net income. >> Your sister is exactly right. If we use regular
netting
com in return assets and return on sales, it will be effective
by a company's financing decisions. So we do have to calculate some
called de-levered netting com, and then use that in place of
netting com in ROA and ROS. So let me show you how that works. So, let's look at
how Leverage
affects return on assets. Ideally, return on assets would
measure operating performance independent of any of
the company's financing decisions. The problem is that the numerator of ROA,
Net income, includes interest expense. Which means that the more
leverage a company took on, the higher its interest expense would be. And the lower
its net income. So to remove all the financing effects
from ROA we have to de-lever Net income. So now ROA is going to be de-levered net
income divided by average assets where de-levered net income is defined as net
income-plus after tax interest expense. So after taxed Interest Expense, it's gonna
be Interest Expense
x 1- the tax rate, which is t. Let me show you a quick example. We have two
companies, one that has
no debt, one that has some debt. They have identical Pretax,
pre-interest income of 300. The company with some debt
has Interest Expense, whereas the no debt company doesn't. Which means the some
debt
company has lower pretax income. We multiply that times the tax rate, and we see
that the some debt company has
lower net income than the no debt company. But then if we add back
after-tax interest expense, which would be 50 (1-.35), voila, we get identical de-
levered
net income between the two companies. So de-levered net income is not
affected by borrowing decisions. So our corrected DuPont Ratio Analysis
Framework, we're gonna use de-levered net income in ROA and we're gonna use
de-levered net income in Return on Sales. >> This is so boring. Can you show us
some
actual numbers already? >> Okay, okay, thanks for
pushing me along. What you should do right now, is go
find the spreadsheet for Wolf Junction, because we're gonna go through the ratios
for Wolf Junction the rest of the video. So if you open up
the Woof Junction spreadsheet, you'll see a tab called Ratios. And at the top, we
have the ratios for
the Dupont analysis. And what I encourage you to do
on your own, after this video, is look at the different formulas so
you can see how it pulls in data from the original financial
statements in the first half. So anyway, we start with Return on Equity. And we can
see there's an upward trend and very steep upward trend
in Return on Equity. So this 40% percent means that for
every dollar of investment that Woof has gotten from their shareholders, they're
returning about 40 cents of net income. I'll also give you the average over
the four years which we'll use later on. So what explains this upward
trend in Return on Equity? Well we can look at the two drivers
Return on Assets and Financial Leverage. Now, I've thrown in a third factor,
a Correction Factor, cuz remember for Return on Assets,
we now use De-levered Net Income. So once you put in De-levered Net Income, ROE is
no longer equal
to ROA times leverage. You also have to add a Correction Factor. Which is the ratio
of net income
to De-levered Net Income. This is not important, we're not going to do anything
with this,
I just put it in for completeness. Instead, we're gonna focus
on Return on Assets. Strong upward trend in operating
performance, so if you look at this 24%, for every dollar of assets, Woof now
generates about 24 cents in profit. In terms of De-levered Net Income. If you look
at Financial Leverage,
it's been fairly steady, so this 1.68 means that for every dollar
of investment from shareholders, Woof buys about $1.68 of assets, so
they're getting about 0.68 of debt. So we can say that what's been
driving their upward trend and return in equity is an upward trend
in their operating performance. So now we can look at the two
drivers of operating performance. Return on Sales or Profitability and
asset turnover efficiency. So what we see again a nice
upward trend and Return on Sales. This 9.2% means that for every dollar of sales,
Woof earns about nine cents of profit. When we look at Asset turnover,
it's sort of an up and down. There is no clear trend. What this 2.62 represents is
for
every dollar of assets, Woof generates about $2.60 of sales. But there hasn't been
a real trend in this, so we can say that the whole reason for
Woof's improvement in return on equity has been driven by their operating
performance, return on assets. And their improve on operating performance
is almost exclusively driven by their profitability or Return on Sales. >> Maybe
every company had a good year. Shouldn't we compare
them to other companies? >> Makes sense. But what other companies should we use? >>
Excellent point. So the ratios have shown us that
Woof Junctions had a great improvement in performance. But what we don't know is
whether
Woof Junction management has done something special to
trigger that performance. Or whether the whole industry
is performing better and maybe Woof is not even doing as well as
the rest of the industry over this period. So we need to find some competitors
to compare Woof Junction to. So let's spend about a minute or so to talk about some
ways that
you can find good competitors so that you can compare other company's
to the company you're interested in. So let's briefly talk about different
ways you could find comparison firms. So every company has some kinda've
standard classification code for what industry they're in. One method are called
SIC Codes. Another method is called NAICS Code. And you can click on these links
and
find out what the codes are and then once you've find out a code for
a company, you can find other companies
with the same code. Another approach is to look
at our security analyst and data services use as comparisons. So, if you pick up
a security analyst report, they'll often mention
the company's competitors. If you go to Google Finance or
some of these other sites, they'll give you a list
of related companies. And then Reuters gives you industry and sector averages which
you
could use as comparisons. In the end you wanna use your judgement on
whether companies are good competitors or not based on taking a look at their
business and their segments to make sure they're similar to the company
that you're looking at. So let's do a a comparison for
Woof Junction. In the spreadsheet, I have one of
their competitors, Ooh La Lab, and I also have the average for
the Specialty Pet Retail Group. So for Woof Junction,
we can see that their average ROE is higher than Ooh La Lab and higher
than the Specialty Pet Retail Group. And remember for Woof Junction
we said upward trends in ROE, also for ROA, and return on sales. But if we look at
the competitor,
Ooh La Lab, there's not an upward trend. In fact,
it's going down the last three years. A similar thing for
the Specialty Pet Retail Group. We can look at Return on Assets or
operating performance. Woof is doing better than Ooh La Lab and
the industry group as a whole. Despite the fact that
they have lower leverage, their higher return on assets
gives them higher ROE. Then we can look at their Return on
Asset drivers, Return on Sales and Asset turnover. We find is that Woof has about
the same
Return on Sales as Ooh La Lab. So how do they have more Return on Assets? Well,
they have higher Asset turnover
at the same level of profitability. So Woof is able to generate more sales for
their assets than Ooh La Lab. Both companies do better
than the index as a whole. And again,
you don't see the same upward trends in profitability that you saw for Woof. So it
looks like the secret
to Woof's success is upward trend in profitability that's
not mirrored by the industry. And they've been able to do that
at a higher level of turnover than their competitors. That wraps up our DuPont
analysis of Woof Junction. What we've seen is that they're large and growing
advantage in return
on equity over Ooh La Lab and the industry has been driven by their
steady increases and profitability. And their consistently higher
level of asset turnover. In the next video, we're gonna dive
deeper into each of those ratios, and see if we can tie back to their
strategy to see what, specifically, they're doing that's giving them such
a big advantage over their competition. I'll see you next time. >> See you next
video.