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The Du Pont identity breaks down Return on Equity (that is, the return to equity that investors have contributed to the firm) into three distinct elements. This analysis allows the analyst to understand where superior (or inferior) return is derived from by comparison with companies in similar industries (or between industries). The Du Pont identity is less useful for some industries, such as banking, that do not use certain of the concepts or for which the concepts are less meaningful. Variations may be used in certain industries, as long as they also respect the underlying structure of the Du Pont identity. Du Pont analysis relies upon the accounting Identity , that is, a statement (formula) that is by definition true. EXAMPLES High turnover industries Certain types of retail establishments, particularly grocery stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under or over-performance. For example, Same Store Sales of many retailers is considered important as an indication that the firm is deriving greater profits from existing stores (rather than showing improved performance by continually opening new stores). High margin industries Other industries, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may be critical. The Du Pont identity allows analysts to determine which of the elements is dominant in any change of ROE. High leverage industries Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. In contrast, however, many other industries would see high levels of leverage as unacceptably risky. Du Pont analysis allows the third party (relying primarily on the financial statements) to compare leverage with other financial elements that determine ROE between similar companies. ROI AND ROE RATIO The return on investment (ROI) ratio developed by Du Pont for its own use is is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover.1 : The return on equity (ROE) ratio is a measure of the rate of return to stockholders.2 Decomposing the ROE into various factors influencing company performance is often called the '''Du Pont system'''.3 : :Where
This decomposition presents various ratios used in Fundamental Analysis .
ROE can also be stated as:4 ::ROE = Tax burden x Interest burden x Margin x Turnover x Leverage ::ROE = Tax burden x ROA x Compound leverage factor Profit margin is (Net profit ÷ Sales), so the ROE equation can be restated: : REFERENCES EXTERNAL LINKS |
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