The DuPont Process is a method of breaking down financial ratios into multiple components for the purpose of analyzing trends and areas of strength/weakness within them. Starting with Return on Equity, we break it down into various profitability and efficiency ratios, capital components, revenue, and various other components of the firm’s financials. In this we see the true make up of inclusive ratios such as ROE or ROA.
The best way to explain this will be through example, so lets use Home Depot’s financials for the years 2007-2009 (Appendix F). Return on Assets (ROA) is a profitability ratio showing us management’s efficiency in using the assets of the firm to generate earnings. It is Net Income over Total Assets. In the case of Home Depot (NYSE:HD), the ROA is 5.29% [2,260,000/41,164,000]. However, to further view the ROA of this firm and its different components, we can look at Net Profit Margin X Total Asset Turnover. This will show us an efficiency ratio as well as a profitability ratio and give us more insight into the make up of the 5.49% ROA that we see (and by comparing these breakdown features with similar firms, we can decide if the value is high or low, favorable or unfavorable). In Home Depot’s case, Net Profit Margin is 3.17% and Total Asset Turnover is 1.67. The product of our Net Profit Margin and Total Asset Turnover is 5.29%. Here is what this looks like in mathematical terms:
So as can be seen above, Return on Assets can be broken down into two other ratios, Net Profit Margin and Total Asset Turnover. When these two ratios are combined, the Revenue cancels out leaving us with the components of Return on Assets, however, allowing us to view it from different aspects of the financials.
The next step in this process is to view these components as a time series to find trends in the data. Lets look at the same ratios for 2008 and then compare to 2009.
Looking at the above analysis we see that ROA went from 9.1% in 2008 to 5.29% in 2009. This means that management was not as efficient at managing the assets of the firm to produce earnings as it was last year. Looking deeper we can see what the cause of this was through DuPont analysis. Margins of the firm dropped 34.7% from 2008 to 2009 while Total Asset Turnover raised slightly from 1.6 to 1.67. This large drop in the Net Profit Margin for Home Depot is the cause of the lower ROA in 2009. This then leads to further analysis:
- Are they losing market share?
- Did their competitors lose similar pricing power?
- What was the ROA change for their competitors?
- Is this temporary or a new norm for HD?
- Are they working on improvement to boost future margins?
By graphing these changes over a long period of time, very informative trends begin to emerge that can tell you a lot about a company, its resources, and the management of those resources.
The DuPont process above continues to breakdown various components of firm’s ratios for further and deeper analysis. Sticking with Home Depot, let’s look at a breakdown of the margins that we found to diminish over the one year period of 2008 -2009. Net Profit Margins are made up of Operating Profit Margins, the Effects of Non-Operating Items, and Tax Effects. By looking at these components we can see if the decrease was actually a loss of pricing power, a tax effect that hit the income statement, or a loss resulting from non-operation activities.
If the company’s Effect of Non-Operating Items is less than 1, then the there is a non-operating expense; greater than 1 means there is non-operating income. Similarly, the tax effect shows us what effect the taxes have on our margins (greater than 1 increasing them, and less than one decreasing them). Following is the DuPont Process for Net Profit Margins during 2008 and 2009 for Home Depot:
Further analysis of the drop in Net Profit Margin and therefore Return on Assets is due partly to a greater negative impact of non-operational activities, however only slightly. The majority of the decline came from lower operational margins, pointing us to further research the areas below:
- Cost of Goods Sold Costs
- Research and Development Costs
- Selling General and Administrative Costs
Therefore, from the DuPont Process, we have gone from a decline in ROA to a specific cause, and have pinpointed the problem with in the company.
Our original purpose for the DuPont process was to look at what we consider to be one of the most important financial ratios, Return on Equity. Taking what we have already built, we will now add a risk or leverage component known as Financial Leverage to the ROA breakdown.
Financial Leverage shows how much the debt the firm is using to finance activities. This can help earnings greatly, but can also hurt them fast in the event of a business downturn (see the Financial Leverage section under Margins). Let’s use this model to show the differences between the Return on Equity for Home Depot and Lowes:
The quick conclusions that can be drawn from this quick comparison are as follows:
- HD employs more financial leverage
- HD has a higher asset turnover
- LOW Net Profit Margins are Higher
- This is due to higher Operating Margins
- And to lower impact from Non-Operational Items
- The overall Return on Equity for the two firms is equal
- However, the risk of the two is clearly different as seen by the financial leverage
- If business conditions should turn for the worse, HD’s ROE will decline much faster than LOW
- Further analysis must be done in the individual historical trends of the firms for each component of ROE.
In conclusion, it is helpful to look past common used financial ratios in order to further diagnose their cause, and even more importantly, their risk. As can be seen above, Home Depot and Lowe’s have similar ROE’s, however, Home Depot employs a lot of risk in order to maintain theirs. This leads us to look at their debt levels and management of that debt. In the even of a market downturn, a portfolio holding Lowe’s would probably fair better seeing that the ROE would not slide as far as fast as Home Depot’s would. Cross sectional (company to company) and time series (one individual company through time) ratio analysis can show many revealing attributes and risks behind many of the popular ratios.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.