dupont [CapiPedia]

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======dupont======
DuPont Analysis (also known as the 'DuPont Identity' or 'DuPont Model') is a powerful framework that dissects a company's [[Return on Equity]] (ROE) into its key drivers. Think of it as popping the hood on a car: instead of just knowing the car is fast (high ROE), you get to see //why// it's fast. Is it a powerful engine (high profitability), a lightweight frame (efficient asset use), or a shot of nitrous oxide (high debt)? Developed by the [[DuPont]] Corporation in the 1920s to evaluate its business operations, this analysis helps investors understand the sources and, more importantly, the //quality// of a company's profitability. It moves beyond the headline ROE figure to reveal whether returns are being generated through genuine operational excellence or risky financial engineering. For a value investor, this distinction is everything.
===== The Classic 3-Step DuPont =====
The most common version of the DuPont analysis breaks ROE into three core components. This simple formula tells a surprisingly rich story about a company's strategy.
The formula is: **ROE = Net Profit Margin x Asset Turnover x Equity Multiplier**
Let's break down the ingredients:
  * === Net Profit Margin ===
    This is calculated as **([[Net Income]] / [[Revenue]])**. It measures a company's profitability and pricing power. In simple terms, it answers the question: "For every dollar of sales, how many cents does the company keep as pure profit?" A higher margin suggests the company is very efficient or sells a unique product that commands a high price.
  * === Asset Turnover ===
    This is calculated as **(Revenue / [[Average Total Assets]])**. This metric measures how efficiently a company uses its assets (like factories, equipment, and inventory) to generate sales. It answers: "How much bang for the buck is the company getting from its assets?" A high turnover ratio is the mark of a lean, mean, operating machine.
  * === Equity Multiplier ===
    This is calculated as **([[Average Total Assets]] / [[Average Shareholders' Equity]])**. This is a measure of [[Financial Leverage]]. It reveals how much of the company's asset base is funded by debt. A higher number means more debt. It answers: "Is the company using borrowed money to amplify its returns?" While some leverage can be good, too much can spell disaster if things go wrong.
===== Putting It All Together: A Simple Story =====
Imagine two companies, "Groovy Gadgets Inc." and "Leveraged Luxuries Co." Both proudly report an ROE of 24%. On the surface, they look equally attractive. But the DuPont analysis tells a different tale.
  * **Groovy Gadgets Inc.:** 8% Profit Margin x 1.5 Asset Turnover x 2.0 Equity Multiplier = 24% ROE
    - //The Story:// Groovy Gadgets is a solid business. It has a respectable profit margin and works its assets reasonably hard. It uses a moderate amount of debt. Its success is balanced.
  * **Leveraged Luxuries Co.:** 3% Profit Margin x 1.0 Asset Turnover x 8.0 Equity Multiplier = 24% ROE
    - //The Story:// Warning bells! Leveraged Luxuries has razor-thin margins and is sluggish in using its assets. It achieves its high ROE almost entirely by using a massive amount of debt (its assets are eight times its equity). This is a much riskier business; a small hiccup in its operations could make it difficult to service its debt.
The DuPont analysis clearly shows that Groovy Gadgets is the higher-quality business, a fact hidden by the identical headline ROE figures.
===== The 5-Step DuPont: A Deeper Dive =====
For those who want even more detail, the 5-step DuPont (or extended) model breaks the [[Net Profit Margin]] down further. This helps to isolate the effects of a company's financing and tax strategies from its core operational performance.
It separates the Net Profit Margin into three parts: the company's operating skill, its interest burden, and its tax burden.
The 5-step formula is: **ROE = (Tax Burden) x (Interest Burden) x (Operating Margin) x (Asset Turnover) x (Equity Multiplier)**
The new components are:
  * **Tax Burden:** ([[Net Income]] / [[Earnings Before Tax]] (EBT)). This shows the slice that goes to the tax authorities.
  * **Interest Burden:** (EBT / [[Earnings Before Interest and Taxes]] (EBIT)). This reveals the impact of interest payments on profits.
  * **[[Operating Margin]] (or EBIT Margin):** (EBIT / Revenue). This is a pure measure of a company's core business profitability before financing costs and taxes are considered.
This extended version allows an analyst to see, for example, if a company's ROE improved because its core operations got better or simply because it benefited from a lower tax rate that year.
===== Why Value Investors Love the DuPont Analysis =====
Value investors aren't just looking for cheap stocks; they are looking for //great companies// at fair prices. The DuPont framework is a perfect tool for this mission.
  * **Focus on Quality:** It helps an investor distinguish between a company generating high returns through operational excellence (high margins and/or turnover) and one that is simply using a dangerous amount of debt. The former is a high-quality business; the latter is a high-wire act.
  * **Superior Comparison:** It is an invaluable tool for comparing direct competitors. If one retailer has a much higher ROE than another, DuPont will show you exactly why—is it better pricing, more efficient inventory management, or just more debt?
  * **Spotting Trends:** By tracking a company's DuPont components over several years, an investor can spot early warning signs. For example, you might see that a company is masking its falling profit margins by taking on more and more debt each year. This is a classic red flag that a simple ROE chart would miss.