Explained: DuPont analysis and its interpretation

DuPont analysis helps to find out exactly what operation or activity is contributing to the rising or declining ROE.

The main goal of every investor is to create wealth in the long term. Naturally, as an investor, you would always be concerned about the ROE a company generates for its shareholders. Because nobody would want to invest in companies that are not generating enough wealth for their stakeholders. This is one of the key reasons why the ROE of a company is important.  

But how do you analyze why the ROE of a company is going up or down? Here comes the DuPont analysis. 

This analysis enables an investor to find out exactly what operation or activity is contributing to the rising or declining ROE. It does so by breaking the ROE into smaller parts.  

While the conventional ROE is calculated by dividing the net profit by the shareholder’s equity, DuPont analysis breaks this formula down into smaller parts.  

The 3 factor DuPont analysis is calculated as- 

(Net profit/Sales) * (Sales/Assets) * (Assets/ Shareholders’ equity) 

For ease of understanding, let’s call these 3 factors A, B and C. 

Factor A helps to calculate the net profit margin. Factor B is the asset turnover ratio, whereas factor C denotes the financial leverage, aka equity multiplier.  

The factors, when broken down in this fashion, tell us about the drivers of ROE.  

For example, a rise in factor A could mean that the company is earning more from the sale of its goods and services. A rise in factor B would denote that the revenue from sales has increased relative to the assets of the company. However, a rise in factor C would denote that the company has incorporated more debt in its capital structure, meaning higher leverage.  

A rise in factors A and B is desirable, whereas a rise in factor C could make the company a risky investment.