Question

Can you explain this further,"  DuPont analysis is an equity evaluation approach..."

In your opinion, what does that mean.

Answer 1

Solution:-

DuPont analysis as a tool for equity evaluation:

Every equity investment is made with the objective of earning maximum ROE possible. Higher the ROE, better the investment and vice-versa. DuPont analysis is a method of analysing the Return on Equity (ROE) of a business. In other words, DuPont analysis is essentially a framework (i.e. a method) that helps investors breakdown the ROE of a business to facilitate its analysis in order to evaluate the strengths and weaknesses of the underlying business's financial performance.

By doing so, the investors are able to evaluate the drivers of returns on equity invested in the business.

In more simple terms, DuPont analysis helps investors evaluate the factors that drive the ROE of an equity investment made by them.

Let's look at the formula for DuPont analysis:-

ROE= Net profit margin*Asset turnover ratio*Equity Multiplier

Let's breakdown the formulas for each component to understand how they represent ROE when combined together.

Net profit margin= Net profit/Sales

Asset turnover ratio= Sales/Avg assets

Equity multiplier= Avg assets/Avg equity

Thus, when all the above three are multiplied, they yield (Net profit/Avg equity) or ROE as a result.

Net profit margin shows the operating efficiency of a business, Asset turnover ratio shows the efficiency with which the company uses its assets and Equity multiplier is the financial leverage of the business. All these factors influence the ROE and thus when combined together, they yield the ROE of the business.

Meaning of 'DuPont analysis is an equity evaluation approach':-

Based on the explanations above, the DuPont analysis helps investors evaluate the factors that determine the return on their equities and hence lets them evaluate equity from the perspective of the pros and cons of various factors relevant to it.

A business' ROE could be higher than its competitors due to great operating efficiency (compared to its competitors) or it could be lagging due to bad asset efficiency (compared to the peers). Thus, DuPont helps investors evaluate the factors that are influencing ROE in good or bad ways. Such analysis forms the core of evaluating equity investments by investors.

Due to the above reason, DuPont analysis is called as an equity evaluation approach.