How to use DuPont Analysis for Financial

Analysis: Soft-Drink Example

August 8, 2012 · by The Financial Intern · in Financial Analysis · Leave a comment

One of the strongest indicators for a financially successful company is return on equity, or
simply ROE. ROE is a great tool for investors because it shows you what the return is on the
portion of the company that belongs to equity. It is a simple calculation that quickly summarizes
the ability of management to turn shareholder equity into profitable returns.

This is one of Warren Buffett CEO of Berkshire Hathaway, favorite calculations for
finding quality companies. If you are unfamiliar with Warren Buffett, he is one of the
world’s richest men (I think he’s 3rd at the moment) and he obtained the vast majority of
his wealth through owning stocks and parts of companies.

I am a pretty big fan of Warren Buffett, so naturally I gravitate towards ROE. I personally like
to look for a company that has been producing ROEs over 15%. The average for the S&P 500
has been around 12% for the past 3 decades or so, so I like to look at companies who have been
better than average. The second thing I look for is consistency. I don’t like companies who will
have 20+% one year, then single digits the next year, and so on. I like steady ROEs. If a
company is consistently in a range, to me it indicates that managers know what they are doing
and are putting the shareowner’s money to good use.

But ROE can be a tricky indicator. You see, ROE can easily be manipulated. There are very
simple ways to produce high ROEs without really increasing the performance of the company.
One of the easiest ways to increase ROE is to increase debt. By increasing your debt amount
your equity portion becomes relatively smaller. Since ROE’s denominator is equity, the smaller
equity becomes the higher ROE becomes. This is because the company is using leverage to
produce growth. Using large amounts of debt can produce high returns, but they can also make
the company less stable in down markets. So I like to stay away from companies that rely on
debt (leverage) to produce strong ROEs.

There are two other indicators that I really like to analyze in a company: EBIT margin and asset
turnover. Ideally I would like to see a company with high numbers for both of these, but that’s
not always possible. It is a must that the company has at least one of these performing better
than the industry standard. If the asset turnover is low, then the profit margin better be high (a
specialty producer with a competitive advantage… think BMW). If the profit margin is low,
then the asset turnover better be high (a low cost provider with large market share… think Wal-
Mart).

So where does DuPont Analysis come in? DuPont Analysis breaks ROE into separate parts and
lets you see exactly where the ROE is coming from. You can see if they are just growing because
of leverage or if they are becoming more profitable and selling more products or reducing costs.

Now if you were to look at a DuPont Analysis for a single company over a single year the
number would be pretty useless. Sure you could see what the ROE, asset turnover, profit
margin, tax burden, leverage, and interest burden are, but you would have no clue if those
numbers were good.

What you need to do is use the DuPont Analysis to compare different companies in the same
industry over some time period (multiple DuPonts). This will show you the trend of the
company against itself and against competitors. I would like to give you an example of using the
DuPont Analysis in the soft-drink industry. I will be comparing Coca-Cola, PepsiCo, and Cott
Corporation.

But before we jump into the analysis, let’s quickly go over how the DuPont Analysis is formed.
I remember in University that a lot of people thought that DuPont Analysis was a way to find
ROE. It’s understandable that people would think this because many of the questions given in
University courses would require you to find the missing values of the DuPont Analysis, or to
find the ROE. But in reality you will have all the parts available to you. You will never have to
find the missing “values”. DuPont is an “analysis” it’s a tool to compare a company to itself and
to its competitors.

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.