Before understanding about Du pont one must know what is the meaning of ROE (return on equity), it is defined as

ROE = net income / shareholder’s equity

If it is high, it is generally a great sign for the company as it is showing that the rate of return on the shareholders equity is going up. The problem is that this number can also increase if company takes debt which in turn will increase the leverage of the company, which could be a good, but it will also make the stock more risky because of extra interest and debt repayments. A simple calculation of return on equity may be easy, and tell quite a bit, but it does not provide the whole picture. Now let us see what Du pont is:

Three-Step DuPont

The three-step equation breaks up ROE into three very important components:
ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

Taking the ROE equation: ROE = net income / shareholder’s equity and multiplying the equation by (sales / sales), we get:

• ROE = (net income / sales) * (sales / shareholder’s equity)

We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont identity:

• ROE = (net income / sales) * (sales / assets) * (assets / shareholder’s equity)

This equation for ROE breaks it into three widely used and studied components:

• ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

We have ROE broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how efficiently the company makes use of its assets), and equity multiplier (a measure of how much the company is leveraged).

If a company’s ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the company. However, if the equity multiplier is the source of the rise, and the company was already appropriately leveraged, this is simply making things more risky.

Even if a company’s ROE has remained unchanged, examination in this way can be very helpful. Suppose a company’s ROE is unchanged. DuPont analysis could make clear that both net profit margin and asset turnover decreased, and the only reason ROE stayed the same was a large increase in leverage which will be a bad sign.

Hence it can be seen that Dupont provide deeper understanding of a company’s return on equity, by examining what is really changing in a company rather than looking at one simple ratio.

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