Using the Dupont Model for ROI Analysis
The Dupont Model is a valuable tool for business owners or investors to use to analyze their return on investment (ROI) or return on assets (ROA). The extended Dupont Model also allows for analysis of return on equity. There are so many financial ratios for a business owner to analyze that it is often easy to get lost in the details. Using the Dupont Model allows the business owner to break the firm's profitability down into component parts to see where it comes from.
Calculating the DuPont Model for either the return on investment (ROI) or the return on equity (ROE) for an investment or a business enterprise involves several steps.
Calculate Dupont for ROI
When analyzing an investment or a business you should start by first, looking at the company's ROI. This is also known as the Return on Assets (ROA) ratio. This ratio tells you how efficiently you have been using your asset base to generate sales.
ROI = Net Income/Total Assets = _____%
Here, net income is taken from the income statement, and total assets are taken from the balance sheet.
As an example, let's say that ABC, Inc., a small hardware firm, generated $113.5 million in sales in 2018 and had total assets of $2,000 million. Then, the calculation for ROI would be:
ROI (ROA) = $113.5/$2,000 = 5.7%
It doesn't tell you much, but if you look at a source for industry average ratios like Bizminer.com, you can compare your ROI with that of your industry. If your industry average is, for example, 9.0% for small hardware firms, then you know what your ROI is below the industry average. The ROI can help an investor determine if an investment in one company may perform better than that in another, similar business.
Component Parts of ROI
ROI is composed of two parts, the company's profit margin and the asset turnover—the firm's ability to generate profit and make sales based on its asset base. Since the ROI (ROA) for ABC, Inc. is below the industry average, you want to find out why. To do that, you can use the Dupont Model and break down the ROI into its component parts. ROI will look like this:
ROI = Net Income/Sales X Sales/Total Assets = _____%
Here, Net Income/Sales is the net profit margin and comes from the income statement and Sales/Total Assets is the Total Asset Turnover and sales come from the income statement, and total assets come from the balance sheet.
Next, you want to find out which part of the ROI is causing the problem for your business—the profit margin or the asset turnover. If it is given that the net profit margin is 3.8% and the total asset turnover is 1.5X, then:
ROI (ROA) = 3.8% X 1.5 = 5.7% which is what you got in Step 1.
Now we know what each part of the equation contributed to the return on investment of the firm. ABC, Inc.:
- Earned 3.8 cents for every dollar of sales
- Turned its assets over 1.5X per year.
If the small hardware company industry had a net profit margin of 5.0% and a total asset turnover of 1.8X, ABC, Inc. was low on both counts, particularly the net profit margin.
Calculate Dupont for ROE
ROE is a way to measure the wealth returned to shareholders. It is the profitability ratio shareholders look at most often.
We have determined that the company we are using as an example, ABC, Inc. is performing poorly with regard to their ROI and the industry average. The extended Dupont Model allows us to examine the return on equity in the same way.
ROE = Net income available to common shareholders/Common Equity = _____%
Here, Net Income comes from the income statement and Common Equity is the sum of all the equity accounts on the balance sheet.
The return on equity ratio can be restated in two ways:
- ROE = ROI X Equity Multiplier
- ROE = ROI X Total Assets/Common Equity
The figure for Total Assets is taken from the balance sheet as is Common Equity. The equity multiplier makes ROE different from ROI by adding the effects of debt to the equation.
Using the numbers from the earlier example, you can calculate the ROE for the company.
ROE = 5.7% X $2,000/$896 (common equity from balance sheet) = 12.7%
If the ROE for ABC, Inc. is 12.7% and the industry average for the small hardware industry is 15%, ABC, Inc. is performing poorly with regard to ROE as well as ROI.
Component Parts of ROE
Three elements interact to form the ROE of a company.
- The profit margin
- Total asset turnover ratio—the efficiency with which the firm uses its assets to generate sales
- Equity multiplier—the effect of debt on the firm
For ABC, Inc., the net profit margin and asset turnover, in particular, are weak and are lowering the return on equity.