DuPont Analysis

Analysis of ROA/ROE: Margin, Turnover, Interest burden,

Tax burden
Du Pont Formula
 Disaggregation can be applied in other beneficial ways in
equity analysis, most notably in a technique known as the
Du Pont Formula. (The idea is generally credited to Donaldson
Brown, who developed the formula while at E. I. du Pont de Nemours,
then applied it during the 1920s as vice president of finance at General
Motors.)
 With the aid of the Du Pont Formula, the analyst can
more readily perceive the sources of a firm’s return on
assets(ROA).
DuPont Model
 The return on equity (ROE) is important to both
managers and investors.
 The effectiveness of managers is often measured by
changes in ROE over time, and their compensation may
be tied to ROE-based goals.
 Therefore, it is important that they understand what they can
do to improve the firm’s ROE and that requires knowledge of
what causes changes in ROE over time.

Sudden drop in the ROE concerns, both

investors and managers are probably trying to
figure out why this happened.
The DuPont system is one way to look at
this problem.
 The DuPont system is a way to break down the ROE into
its components so that management can understand how
to improve the firm’s ROE.
 Let’s first take another look at the return on assets
(ROA):

So, the ROA shows the combined effects of

profitability (as measured by the net profit
margin) and the efficiency of asset usage (the
total asset turnover). Therefore, ROA could
be improved by increasing profitability or by
using assets more efficiently.
 As mentioned earlier, the amount of leverage that a firm
uses is the link between ROA and ROE. Specifically:

Note that the second term in (2) is sometimes called the “equity multiplier” and
the proportion Total Assets to Total Equity is equal to:
 Substituting (2) into (3) and rearranging, we have:

We can now see that the ROE is a function of the

firm’s ROA and the total debt ratio.

If two firms have the same ROA, the one using

more debt will have a higher ROE.
 We can make one more substitution to completely break
down the ROE into its components. Because the first
term in (4) is the ROA, we can replace it with (1):

Or, to simplify it somewhat:

Extended DuPont Analysis
 We can take the decomposition of ROE one step further
by breaking the net profit margin into three
components:
 1. The operating profit margin, which measures the basic
profitability from the firm’s day-to-day operations;
 2. The interest burden, which measures the impact of interest
expense on pre-tax earnings; and
 3. The tax burden, which shows the impact of taxes on
overall earnings.
 We have already discussed the operating profit margin.
The interest burden is calculated as:

and the tax burden is calculated as:

 Multiplying these three ratios together gives us the net
profit margin:

Finally, if we substitute equation (8) into the numerator of (5), we have:

The extended DuPont system for calculating the ROE, equation (10), tells us that
the return on equity is a function of operating profitability, the interest rate, the
tax rate, the efficiency with which the firm uses its assets, and the amount of debt
that it uses.
Input required to calculate DuPont ratio
 1. Net Income (NI) or EBIT
 2. Net Sales
 3. Total Assets
 4. Equity and Total Equity (Equity + retained earnings)
 5. Total Debt (Short and current)
 6. Earning Before Tax (EBT)
 7. Interest Burden
 8. Tax Burden
Kellogg Co. DuPont Ratios
 Kellogg Company is a manufacturer and marketer of ready-to-eat
cereal and convenience foods. The Company's principal products are
ready-to-eat cereals and convenience foods, such as cookies,
crackers, savory snacks, toaster pastries, cereal bars, fruit-flavored
snacks, frozen waffles and veggie foods.
 Its segments include U.S. Morning Foods, which includes cereal,
toaster pastries, health and wellness bars, and beverages; U.S. Snacks,
which includes cookies, crackers, cereal bars, savory snacks and
fruit-flavored snacks; U.S. Specialty, which represents food away from
home channels, including food service, convenience, vending, Girl
Scouts and food manufacturing; North America Other, which
includes the U.S. Frozen, Kashi and Canada operating segments;
Europe, which consists of European countries; Latin America, which
consists of Central and South America and includes Mexico, and Asia
Pacific, which consists of Sub-Saharan Africa, Australia and other
Asian and Pacific markets,
Net Income
Total Assets
Ratios & Margins Kellogg Co.
Efficiency, Liquidity and Capital
Structure
All values USD Millions.
2018 2017 2016 2015 2014
Net Sales 13,547 12,854 13,014 13,529 14,583
Net Income 1,336 1,254 694 614 632
EBIT 1,884 1,755 1,707 1,440 1,442
EBT 1,329 1,657 927 773 825
Interest 279 246 411 244 231
Tax 181 410 233 159 186
Total Assets 17,780 16,351 15,111 15,251 15,153
Equity 2,601 2,178 1,910 2,128 2,789
Total Equity 3,159 2,194 1,926 2,138 2,851
Long-term Debt A 8,207 7,836 6,698 5,275 5,935
Current debt B 4,529 4,522 4,474 5,739 4,364
Total Debt (A+B) 12,736 12,358 11,172 11,014 10,299
Depreciation 493 469 460 508 494
Amortization of Intangibles 23 12 7 8 9
EBITDA 2,400 2,236 2,174 1,956 1,945
ROA
Margin 9.86 9.76 5.33 4.54 4.33
Turnover 0.76 0.79 0.86 0.89 0.96
ROA 7.51 7.67 4.59 4.03 4.17
ROA 8% 8% 5% 4% 4%
ROA
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
2018 2017 2016 2015 2014

ROA
ROE
NI/Sales 0.10 0.10 0.05 0.05 0.04
Sales/TA 0.76 0.79 0.86 0.89 0.96
1-TD/TA 0.28 0.24 0.26 0.28 0.32
ROE 26% 31% 18% 14% 13%

ROE
35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
2018 2017 2016 2015 2014

ROE
Extended DuPont :ROE
EBIT/Sales 0.14 0.14 0.13 0.11 0.10
EBT/EBIT 0.71 0.94 0.54 0.54 0.57
NI/EBT 1.01 0.76 0.75 0.79 0.77
Extended DuPont 35% 40% 20% 16% 14%

Extended DuPont(ROE)
45.00%

40.00%

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
2018 2017 2016 2015 2014

extended DuPont
Remarks:
 Like most ratio analysis, the Du Pont Formula is valuable not
only for the questions it answers but also for the new ones it
raises. If a company raises its return on assets by finding
ways to reduce working capital without impairing
competitiveness (thereby improving asset turnover), then it
is likely to be able to perform at the higher level.
 On the other hand, cutting back on necessary capital
expenditures will also have a positive effect—in the short run—
on return on assets. Not only will the denominator decline in
the asset turnover factor as a result of depreciation, but return
on sales will rise as future depreciation charges are reduced by
lower capital outlays in the current year.
 Underspending will eventually hurt competitiveness, and
therefore the company’s long-run return on assets, so analysts
must probe to determine the true nature of shifts in these
ratios.
Du Pont analysis:
Case of Processing Industry
 A Du Pont analysis of the food processing industry (Table 1)
confirms the value of examining the components of return on
equity. Based on ROE alone, Conagra (13.93%) and Kraft
Foods (14.24%) look very similar. They achieved those
numbers by very different methods, however. Conagra, a more
commodity-oriented company, worked on a narrower sales
margin (1.63% vs. 7.54% for Kraft), but turned over its assets
much more frequently (2.06 X vs. 1.28 X).
 McCormick appears to be far more profitable than Hershey
Foods, based on the companies’ respective returns on equity
of 38.27% and 28.47%. That advantage resulted entirely from
more aggressive financial leverage (4.62X for McCormick vs.
Hershey’s 2.93X, the second most conservative ratio in the
industry).
Table1 : Du Pont Analysis of Food
Processing Industry’s 2000 Results*

*Calculations are subject to rounding error.

 Hershey’s return on sales and, consequently, its return on
assets were substantially higher than McCormick’s
corresponding figures. The analysis shows investors that
to benefit from McCormick’s higher return on equity, they
must assume more financial risk than they would
expose themselves to by owning the stock of Hershey
Foods.
 Some of the companies in Table 1 achieved returns on equity
that seem absurdly high, with Sara Lee at 97.06% and Ralston
Purina at 120.93%. In part, those results reflected the two
companies’ employment of the highest financial leverage
within the industry.
 In addition, the extremely high ROEs derived from the
companies’ very low levels of book value. As producers of
branded food products, Sara Lee and Ralston Purina derive
their equity value primarily from the consumer acceptance of
well-known brands, rather than the physical plants in which
they produce their goods.
 On June 30, 2001, Ralston Purina’s stock closed at $30.02 a
share, yet its book value was only $2.36 a share. The company’s
return on equity looks less stratospheric when equity is
viewed in terms of market capitalization rather than historical
cost.