3.5 Extended DuPont Analysis

The Extended DuPont provides an additional decomposition of the Profit Margin Ratio (Net Income/Sales) into two burden components, Tax and Interest, times the Operating Profit Margin.  This is a positive refinement of the traditional DuPont Analysis to provide a refinement of the profit margin ratio into the operating profit margin ratio by taking out the effects arising from taxes and interest expense.  As a result, it provides both management and the financial analyst with finer information about a company and its immediate competitors.

Formally, the Extended DuPont formula is:

Each term in the decomposition has a specific meaning:

Net Income is measured after taxes.  So if taxes are zero the tax burden equals one and so the lower this number, the higher the tax burden.  Similarly, if Interest Expense is zero then interest burden ratio equals one and therefore the higher the financial leverage, the lower is this number.  The advantage of adjusting for taxes and interest is to gain better insight into the firm’s profit margin by focusing upon the operating profit margin.

Note that the product of the first four terms is now ROA.  This is driven by operations, financing and the management of taxes.  A nice property of the Extended DuPont formula is that one can examine the breakdown of ROA from the perspective of major firm decisions --- investment, financing and tax decisions.

The remainder of this decomposition is as before.  That is, the fifth term is again related to the financing decision; a highly leveraged firm has low Shareholders Equity compared to Assets. 

Tutor Reconciliation:  Proctor and Gamble (PG)

Practical Note:  Analysts vary in terms of how they apply the Extended DuPont Analysis.  The most common practical variation from the above definitions is to use the US GAAP definition of income from continuing operations.  The International Financial Reporting Standards (IFRS) does not make the distinction between income from continuing operations and so this practical note only applies to US GAAP.

The default numbers in Valuation Tutor screens have (CO) after them to indicate that this is in relation to Continuing Operations.  The reconciliation provided in this section will illustrate this for Proctor and Gamble using continuing operations.   Users of Valuation Tutor can apply either definition to the net income input field and if comparing across firms you should apply the same convention.

Step 1:  Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.2.  This was displayed at the bottom of the screen as follows:

We can reconcile the Extended DuPont by selecting the Consolidated Income Statement and Consolidated Balance Sheet as follows:

You can see from the above screen that the 10-K income statement for Proctor and Gamble breaks out income from continuing operations ($15,047) and taxes on income from continuing operations ($4,101) from total income from continuing operations after tax ($10,946) versus Proctor and Gamble’s Total Net Income after Tax ($12,736) which was used in the previous topic 3.4.

Step 2:  Refer to the calculator part of the Valuation Tutor screen.  This has computed the Extended DuPont from the following per share fields:

Net Income (CO, Continuing Operations) = 3.756 per share

EBT (Earnings Before Taxes) = 5.3016 per share

EBIT (Earnings Before Interest and Taxes) = 5.6343 per share

Sales per Share = 27.7609 per share

Total Assets per Share = $45.0754 per share

Shareholders’ Equity = 21.4929 per share

Step 3:  Click on Calculate for the DuPont decomposition:

The additional derived fields are:

Tax Burden (CO) = 0.7261

Interest Burden =  0.9410

Operating Margin = 0.2030 or 20.3%

Asset Turnover = 0.6159

Return on Assets (CO) = 0.0854.

Financial Leverage Ratio  = 2.0972

Return on Equity (ROE CO) = 0.1791

That is Proctor and Gamble’s Operating Margin is refined to reveal the margin from continuing operations after adjusting for Tax and Interest burdens.  Again in the next step we verify how these numbers have been estimated from the financial statements.

Step 4:  Where did these numbers come from?

Each of the numbers can be traced back to two primary financial statements:

 For convenience we again relate the numbers in the 10-K to the summary grid as depicted below and then refer to the line numbers in the summary grid.  So for example you can see that the Net Earnings from Continuing Operations after tax is $10,946 and the Total Assets are $128,172 and so on.

The full reconciliation can now be traced through as follows: