Question

Answer each question succinctly yet completely. Be mindful of the multiple parts to each question.

7. Explain the key component ratios in a three-phase DuPont formula. What potential insight could a five-year historical DuPont analysis provide? How—and why—is a historical review of the DuPont components linked to the concept of trend analysis?

Answer 1

The DuPont formula is a method of measuring return performance generated by a company per year on the basis of its book equity value. The formula is so named because it was foirst used as a performance measurement metric by the American DuPont Corporation.

The formula breaks down a company's Return on Equity (ROE) into three components as shown below:

ROE = Net Income / Shareholder's Equity = (Net Income / Revenue) x (Revenue/Total Assets) x (Total Assets/Shareholder's Equity) = Profit Margin x Asset Turnover Ratio x Financial Multiplier

The profit margin component (Net Income/Revenue) measures operational efficiency, the asset turnover ratio (Revenue/Total Assets) determines the efficiency of using assets to generate revenues and the financial multiplier is a measure of the degree to which assets (that generate revenue) are financed by debt.

Hence, the returns accruing to a firms stockholder's are quantified by three factors: the firm's operational efficiency, the firm's asset usage efficiency, and the firm's financial leverage.

A five year historical DuPont analysis could pinpoint the factor(s) (from among the three described above) driving the firm's ROE over a period of time. Further, if the ROE has been falling, the same analysis can specify the factor (from among the three described above) which leads to the aforementioned fall in ROE.

The individual components of the DuPont formula, if and when checked over a period of time point out trends in their change in value. These trends further direct investors to a general direction in which ROE of the firm should move (as the ROE is composed of the three factors described above) thereby constituting a trend analysis.