Investors making equity investment decisions based on return on equity (ROE) may be missing the boat.
ROE is a closely watched number among savvy investors because it’s a strong measure of how effective a company’s management is in creating value for its shareholders. But it can still be misleading.
This is because it’s vulnerable to measures that increase its value which, by default, makes the stock under consideration a more risky investment.
Therefore, investors are in need of a way to break down ROE into its various components to avoid being duped into believing a company is a good investment – when in fact, it’s not.
The DuPont Method
The eponymous DuPont analysis is a ratio and performance measurement developed by DuPont Fabros Technology Inc. (DFT) for internal use.
Fast-forward to today and it’s used by many firms and analysts to evaluate how effectively assets are utilized. It measures the combined effects of profit margins and asset turnover.
The DuPont analysis essentially deconstructs the ROE into the various factors that influence a company’s performance.
Calculating ROE is quite simple, as the equation only consists of two numbers:
If ROE increases, it’s typically a sign that the company’s rate of return on shareholder equity is rising.
But here’s the problem: This number can also rise when the company simply takes on more debt, thereby decreasing shareholder equity.
Yes, it’s called leverage, and although leverage can be a good thing, it also increases a stock’s risk.
In an effort to avoid mistaken assumptions, analysts required a more in-depth knowledge of ROE, and the DuPont Corporation addressed that specific issue by creating a method of analysis that breaks down ROE using a more complex equation.
The DuPont method (or “DuPont identity”) measures assets of a company by its gross book value rather than net book value.
In applying the DuPont analysis, ROE is affected by three things:
- Operating efficiency – measured by profit margin,
- Asset use efficiency – measured by total asset turnover, and,
- Financial leverage – measured by the equity multiplier.
The equation is:
ROE is, thereby, broken down into net profit margin (how much profit the company gets from its revenues), asset turnover (how effectively the company makes use of its assets), and equity multiplier (a measure of how much the company is leveraged).
Many will claim that measuring assets using gross value – rather than net book value – removes the incentive to delay, or avoid investing in new assets.
Why? Because new asset avoidance tends to occur as the depreciation methods applied in financial accounting artificially produce lower ROEs, particularly in the initial years when an asset is placed into service.
So if it turns out that ROE is unsatisfactory, the DuPont model can help to reveal the parts of the business that are underperforming.
Real World Application
The DuPont Three-Step-Model is as follows:
Begin by taking a closer look at a high margin industry – for example, high-end fashion – which can derive a significant amount of its competitive advantage from selling at a higher margin (versus higher sales).
For many retailers, increasing sales without sacrificing margin is a factor that may be critical in maintaining profit.
Applying the DuPont identity can help to determine which of the elements is dominant in any change of ROE.
In a high turnover industry – such as grocery stores – a significant multiple of assets are sold in the course of a year. The ROE may be particularly dependent on performance of this metric, and thus asset turnover must be analyzed carefully for signs of under- or over-performance.
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Retailers commonly consider “same-store sales” when examining their profit margins. This refers to the difference in revenue generated by a retail chain’s existing outlets over a certain period – often a fiscal quarter or a particular shopping season – compared to an identical period in the past.
Same-store sales offer companies an important measure, as it indicates whether or not the business is deriving greater profits from existing stores, as opposed to showing improved performance by opening more stores.
Finally, look at a highly leveraged industry such as financial services.
Banks and financial institutions typically rely on high leverage to generate acceptable ROE, unlike other industries that view high leverage as unacceptable and risky. By assessing financial statements of these institutions, the DuPont analysis enables analysts to compare leverage among similar companies.
Five-Steps to Up the Game
There is a second, extended variation of the DuPont referred to as the five-step equation, which takes this method of analysis even further.
As discussed, when a company’s ROE rises as the result of an increase in the net profit margin or asset turnover, it’s a positive sign for the company. If the equity multiplier, however, is the source of the rise, and the company was already appropriately leveraged, it’s a sign of higher risk.
If the company is over-leveraged, the stock price may then warrant a discount irrespective of a higher ROE. Or the company could be under-leveraged, indicative of its being better managed.
But what if ROE remains unchanged? Utilizing the DuPont analysis could then show that both net profit margin and asset turnover have actually decreased, both of which are negative signs for the company. Thus, the only reason ROE stayed the same was due to a sizable increase in leverage – a bad sign.
This is where the Five-Step DuPont Method comes in handy, as it breaks down net profit margin even further. The equation shows that increases in leverage don’t always indicate an increase in ROE.
Since the numerator of the net profit margin is net income, this can be turned into earnings before interest and taxes (EBIT) by multiplying the three-step equation by 1 minus the company’s tax rate, which results in the following calculation:
- Operating Profit Margin = EBIT / sales
- Asset Turnover = sales / assets
- Interest Expense Rate = interest expense / assets
- Equity Multiplier = assets / equity
- The tax retention rate = 1 – tax rate
If a company has high borrowing costs, its interest expenses on additional debt could negate any positive effects of the leverage.
Using the Five-Step Method can help to conclude that one company has a lower ROE than another because its creditors perceive the company as riskier and charge it a higher rate of interest. Alternatively, the company could have poor management and too little leverage; or its higher costs are decreasing its operating profit margin.
Ultimately, both the Three- and Five-Step equations provide deeper understanding of a company’s ROE by examining what’s really changing in a company.
If a company’s ROE is lower than that of its peers, these methodologies can help identify where the company is lagging, or alternatively how a company is lifting or propping up its ROE.
This type of analysis is crucial when it comes to identifying a solid investment.