3.4 DuPont Analysis

As we showed, fundamental growth for a firm equals Return on Equity (ROE) times the Retention Ratio (RR):

The DuPont model re-expresses the accounting return on equity (ROE) as the product of the Return on Assets (ROA) and Financial Leverage (measured by Total Assets/Shareholders’ Equity).   ROE and ROA are two major ratios that are associated with the “Financial Perspective” of the balanced scorecard.

The DuPont decomposition has an interesting history:

Among the stocks that currently make up the Dow Jones Industrial Index the oldest is E. I. du Pont de Nemours And Company more commonly referred to simply as DuPont.  DuPont was originally a gunpowder mill founded in July 1802 by Eleuthère Irénée du Pont and today is one of the largest chemical companies in the world. DuPont was a pioneer with respect to management accounting systems, including devising the accounting ratio Return on Investment (ROI).  Around 1912 their ROI approach was extended by one of their financial officers, Donaldson Brown, who decomposed the ROI calculation into a product of the sales turnover ratio and the profit margin ratio.  In 1914 DuPont invested in General Motors (GM) to assist the struggling automobile company.  In 1920, Pierre DuPont became chairman of GM, and during his tenure implemented a pioneering management accounting system that focused sharply on planning and control.  By organizing resources around this system GM grew to be the largest automobile company in the world.  In 1957 DuPont had to divest itself of General Motors because of the Clayton Antitrust Act.  The DuPont decomposition became popular after its successful use at GM and DuPont.

As a reminder, we note that ROE = Net Income/Shareholders Equity, and ROA = Net Income/Total Assets.  ROE measures the rate at which shareholder wealth is increasing, while ROA measures the productivity of the assets in generating income, and therefore measures the efficiency of the investment decision.

Formally, the DuPont formula is:

Each term in the decomposition has a specific meaning:

 Note that the product of the first two terms is ROA.  The third term is related to the financing decision; a highly leveraged firm has low Shareholders Equity compared to Assets, while as before, the ROA results from the investment decision. In the DuPont formula, the effects of the investment decision are further decomposed into the product of operating efficiency as measured by the Profit Margin Ratio and asset utilization efficiency as measured by Asset Turnover Ratio. 

 Tutor Reconciliation:  Proctor and Gamble (PG)

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 DuPont decomposition by selecting the Consolidated Income Statement and Consolidated Balance Sheet as follows:

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

Total Assets per Share = $45.075

Sales per Share = $27.761

Net Income per Share = $4.479

Shareholders’ Equity = 21.4929

Step 3:  Click on Calculate for the DuPont decomposition:

You can observe above the additional derived fields are:

Sales/Total Assets = 0.6159 = Assets Turnover Ratio or Asset Efficiency

Net Income/Sales = 0.1613 = Profit Margin Ratio

Return on Assets = 0.0994 = Product of the Asset Turnover Ratio and Profit Margin Ratio.

Total Assets/Total Equity = 2.0972 = Financial Leverage Ratio

Return on Equity (ROE) = 0.2084

So Proctor and Gamble’s has enhanced its ROA by exploiting financial leverage.  Later in this chapter, you will learn how to interpret these numbers but first:

Step 4:  Where did these numbers come from?

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

For convenience we relate the numbers in the 10-K to a summary grid as depicted below and then refer to the line numbers in the summary grid.  So for example from this you can see that the Net Sales is $78,938 and the Total Assets are $128,172 and so on.