By Timothy P. Connolly, CFA
One of the more interesting and insightful models or systems in financial analysis is the DuPont analysis, named after the U.S. chemical company that began systematically looking at these numbers in the 1920s.
The DuPont analysis is a way of decomposing and examining the financial ratio return on equity (ROE). ROE looks at how much a company earned in the previous period compared with the total amount of owners’ equity invested in the business. The DuPont analysis looks at why ROE is what it is and identifies some of the underlying drivers of the ratio.
One of the nice things about the DuPont analysis is that all the numbers can be taken straight from the income statements and balance sheets provided by companies in their quarterly and annual earnings releases or SEC filings. For our purposes, we are using the most recently filed Form 10-K annual report for Apple, Inc. (AAPL), dated 29 September 2012.
Start With Return On Equity
A DuPont analysis begins with the company’s return on equity (ROE). The formula for that is ROE = Net Income/Equity, as below:
$41,733/$97,413 = 42.84%
When calculating financial ratios that mix balance sheet numbers with income statement numbers like this one, it’s important take an average of the beginning and ending balance sheet numbers for the period, which is what we have done here.
The reason for this approach is that income statements look at activity that happened over the entire period, whereas balance sheets are “snapshots” of the company on one particular day at the end of the period.
So, their return on equity was 42.84%. What does that mean?
Good question. It means that Apple earned almost $42 billion in the most recently ended fiscal year. That’s way more than I earned last year. It did that while having average invested owners equity in the business of $97.4 billion.
Many investment professionals choose to look at this by comparing the opportunity to invest in this business with some other alternatives. They could have had that $97.4 billion invested in short-term Treasury Bills last year and would not have made nearly as much.
The question is WHY or “how” did they earn that 42.84% return on the capital they had invested. Was it because management was efficient? Because they had high financial leverage? What drove that number?
Decomposing Return On Equity
It turns out that we can decompose or break ROE down into component parts through a mathematical identity.
ROE = Net Income / Equity = (Net Income/ Sales) * (Sales / Assets) * (Assets / Equity).
This works because it’s an identity:
Net Income / Equity = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity).
Extracting Information From The Component Pieces
Profit Margin = Net Income / Sales
$41,733 / $156,508 = 26.66%
Profit margin, as the name implies, tells you how profitably you are running the business. Are you barely covering your costs or do you have a pretty good cushion? The more commoditized a product is, the slimmer its margins will be. Apparently, people don’t view the products Apple, Inc. sells as a commodity, since 26% is a very comfortably profitable business.
Asset Turnover = Sales / Assets
$156,508 / $146,218 = 107.04%
Asset Turnover measures the amount of sales a company has relative to the assets it has to own and maintain in order to generate those revenues. The amount of turnover can tell us a fair bit about how the business operates. If turnover is high (as it might be at a hot dog stand or supermarket) or low (as it might be at a low turnover business like a car dealership), we can reach different conclusions. To think about how sales work differently in these two lines of business, remember that there are no “10 Items Or Less” signs in a car dealership: customers usually buy just one car at a time.
Financial Leverage = Assets / Equity
$146,218 / $97,413 = 150.10%
Financial Leverage is an indication of how much Debt the company uses to finance the generation of revenues. As we’ll see, Apple, Inc. is in the enviable position of having no long-term debt outstanding, meaning it has not had to borrow money to acquire the assets it uses to generate revenues, or has paid any debt back already.
So putting those three component ratios together, we get the basic DuPont Analysis:
ROE = Profit Margin * Asset Turnover * Financial Leverage
42.84% = 26.66% * 107.04% * 150.10%
The Extended DuPont Analysis
It’s helpful to know a little bit more about why the return on equity was 42.84%%, and this gives us some finer details to examine. We can actually do to the first component of the analysis, the Profit Margin Ratio, what we did with ROE. That is, we can break Profit Margin, again using a mathematical identity, into its own component parts, giving us an even finer level of detail to explore. This is called The Extended DuPont Analysis.
As we have seen:
Profit Margin = Net Income / Sales
26.66% = $41,733 / $156,508
This can be rewritten using another mathematical identity:
Profit Margin = (Net Income / Sales) = (Net Income / Earnings Before Taxes) * (Earnings Before Taxes(EBT) / Earnings Before Interest and Taxes (EBIT)) * (EBIT / Sales)
We can now look at what drove the Profit Margin to be 26.66%.
Tax Burden = (Net Income / Earnings Before Taxes)
$41,733 / $55,763 = 74.84%
Tax Burden is an indication of how much the company is paying in corporate taxes, or how much of the profit is falling to the bottom line. This calculation indicates that as of the most recent quarter, Apple kept almost 75% of every dollar it makes after expenses.
Interest Burden = (Earnings Before Taxes / Earnings Before Interest and Taxes)
$55,763 / $55,763 = 100%
As mentioned earlier Apple, Inc. has no long-term debt outstanding and therefore, has no Interest Expense to pay to lenders. This means EBT is the same as EBIT. Usually Interest Expense reduces Net Income and therefore, lowers ROE.
Sales Margin = (EBIT / Sales)
$55,763 / $156,508 = 35.63%
Sales Margin is yet another way of looking at how profitable each dollar of revenue is after deducting operating expenses but before deducting interest and taxes.
So again, putting the three ratios together we get:
Profit Margin = Tax Burden * Interest Burden * Sales Margin
26.66% = 74.84% * 100% * 35.63%.
And finally, the complete Extended DuPont Analysis:
ROE = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Sales) * (Sales / Assets) * (Assets / Equity)
42.84% = ($41,733 / $55,763) * ($55,763 / $55,763) * ($55,763 / $156,508) * ($156,508 / $146,218) * ($146,218 / $97,413)
ROE = Tax Burden * Interest Burden * Sales Margin * Asset Turnover * Financial Leverage
42.84% = 74.84% * 100% * 35.63% * 107.04% * 150.10%
Naturally, as an analyst, it would be a most helpful exercise indeed if one were to perform the Extended DuPont Analysis on Apple, Inc. going back over time to see how the trends have been going with the individual components over time. Even more insightful would be to perform the analysis on the other competitors in Apple, Inc.’s industry to see how they stack up relative to Apple, as well as how their component ratios have been trending over time. Let me know how that goes!
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.