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Price is what you pay, value is what you get. The above quote of Warren Buffett is widely used, but very few of us really understand the true meaning of it. Majority of investors look at the price as indicator of whether a stock is cheap or expensive, for example, a stock trading at Rs.10 […]

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One of the biggest challenges every investor faces is how to find companies that are worth investing? And the question is valid, there are more than 5,000 companies listed in the stock market, going through each of them to find a handful of investment worthy stocks is like finding needle in a haystack. That is […]

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Circle of Competence: Circle of competence is an age old concept of value investing, popularized by Warren Buffett. The first time concept of circle of competence gained popularity was when Warren Buffett in his Berkshire Hathaway letter to shareholders wrote: “You don’t have to be an expert on every company, or even many. You only […]

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Durable Competitive Advantage: Durable Competitive Advantage, is a fundamental concept of value investing. Investors like Warren Buffett, Peter Lynch and many more have always advocated for the importance of durable competitive advantage as one of the most crucial factor that determines the long term success, sustainability and longevity of a business. As Warren Buffett says: […]

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”Rule No.1 Never Lose your capital, Rule No.2 Don’t forget rule No.1”. There is a widespread myth in the stock market that in order to get higher return, you have to take more risk. Nothing can be far from truth. The secret of making money successfully in stock market is to focus on minimizing the […]

The post What are Balanced Funds? How They Work? Advantages, Disadvantages, and Who Should Invest? appeared first on INFIMONEY.

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Index Funds: An Introduction Investing in stock market, which was once an option, is now slowly becoming a necessity. With declining interest rates in fixed deposits, which come nowhere close to meeting one’s financial goals, an average person is left with no other option but to invest in stock market. The problem with investing in […]

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”Be fearful when others are greedy, and be greedy when others are fearful” – Warren Buffett The above quote by Warren Buffett sums up contrarian investing in a nutshell, an approach to investing used by some of the most successful investors like Warren Buffett, John Templeton, and Peter Lynch, that has helped them make a […]

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The secret of finding great stocks for long term investment is to find stocks that have great ability to preserve investor’s capital and create a lot of wealth at the same time.

Though there are so many tools that will help you find such stocks, but one of the easiest one is the DuPont Analysis.

In this post on How to use Dupont Analysis to Analyze Companies, we will try to understand what is DuPont analysis and the inner working of DuPont Analysis.

What is DuPont Analysis? The Components:

DuPont Analysis, also known as DuPont Model, is based on return on equity ratio which determines a company’s ability to increase its Return on Equity.

DuPont analysis was created by Mr. Donaldson Brown in 1920, while he was working at DuPont Corporation (hence the name). DuPont analysis, in its early stage was used for measuring the management efficiency.

DuPont analysis breaks down the Return on Equity (ROE) part into smaller portions in order to investigate the root cause of Return on Equity (ROE).

The Dupont Analysis looks at three main components of the Return on Equity Ratio:

Profit Margins

Asset Turnover

And

Financial Leverage

While Profit Margin measures the profitability of a business, Asset Turnover shows how efficiently the assets of the business are utilized to generate revenue.

Finally, Financial Leverage shows how is the business capitalized. In other words, financial leverage is a liquidity ratio that shows how much of a businesses’ total capital is funded by shareholders and how much by debt.   

Using these three major parameters, DuPont analysis can measure the quality of any business.

Let us now move forward and understand the formula and working of DuPont Analysis.

DuPont Analysis: Formula    

The formula used in DuPont Analysis is an expanded form of Return on Equity (ROE).

The Formula for Return on Equity is as follows:

ROE= Net Income / Shareholders Equity

As mentioned earlier, DuPont Analysis uses three factors to analyze the quality of a business, Profit Margins Asset Turnover and Financial Leverage.

The formula for DuPont analysis is as follows:

ROE= Profit Margin * Asset Turnover * Financial Leverage

If you expand each of the components of the above formula, this is something that you will get.

As it is clear from the formula above, DuPont Analysis is simply an expansion of the ROE formula. If you cancel the Net sales and Total Assets, you will get back the formula for ROE.

Every one of these numbers can be easily found on various websites and annual reports of the company.


Also Read:
How to Value a Stock Using Discounted Cash Flow Analysis
How To Analyze Banking Stocks?
DuPont Analysis: Interpretation

DuPont Analysis, using three vital parameters of a business’s growth and sustainability, highlights the strengths of a business and at the same time points out any weakness present.

For Example, a business with high profit margins may look like a great investment, but if it has used excessive leverage (that is, it has lot of debt on its books), it may land into trouble if margins start to shrink, as the business has to keep paying its debt obligations, irrespective of whether it makes a profit or suffers a loss.

DuPont analysis can also be used to find the exact pain points of the business. For Example, if a business has low ROE, you can find the area where it is lagging behind, is it excessive leverage or poor asset turnover?

By understanding the exact issues, you can wait for things to get better in the future, and when things start to improve, you can make a decision to invest.

Dupont Analysis can also be used to compare two or more similar businesses, helping you find which one is better.

For Example, let’s say there are two companies, A and B, both of them have same Net Profit Margin of 15%, making it difficult for you to understand, which one is better.

In order to make a clear decision, you need to look at the other components of DuPont Analysis such as leverage.

If company A has a leverage ratio of 0.5 and Company B has a leverage ratio of 1.2, it clearly shows that Company B has higher leverage, making it a riskier investment compared to Company A.         

Here is a simple Info Graphic that will help you understand the entire concept of DuPont analysis clearly:                

Having learned the steps of DuPont analysis, let us take an example and see how we can use DuPont Analysis to compare and find better investment opportunities.

Example of DuPont Analysis:    

Let us analyze the Return on Equity of two companies X and Y, both of them have ROE of 9%. The Ratios of the two companies are as follows:

Even though the ROE of both the companies are same, the operations of both the companies are completely different.

Company X is able to generate higher profit against each sales as it is evident in higher Profit Margins.

Although Company Y is selling products at a lower margins, it is able to sell at higher volumes which can be seen in its high Asset Turnover Ratio.

Finally, Company Y seems to be less risky investment because of low financial leverage.

Thus, DuPont Analysis helps you in comparing two or more similar companies, it gives you a complete view on quality of a business and measure the risk associated with the business model of each company.

Pitfalls of DuPont Analysis:

Just like every other fundamental analysis model, DuPont Analysis also has some drawbacks which should be kept in mind while analyzing a business.

Some of the major pitfalls of DuPont Analysis are as follows:

It’s not suitable for absolute valuation:

Not exactly a drawback, but this definitely is a limitation of DuPont analysis. DuPont analysis is used to compare two or more similar companies to find which one has better quality fundamentals. DuPont analysis cannot be used for absolute or standalone analysis of a company.    

Does not take consider Valuation as a parameter:

No matter how good a company is, if you pay too much for it, it does not make a good investment.

While DuPont analysis is a great tool for analyzing the quality of a business, it does not take into account how cheap or expensive a company is in terms of valuation and if it is the right price to buy the stock.

Does not work for asset-light business models:

DuPont Analysis uses asset turnover as one of the parameters for analyzing the quality of a company, which can be crucial for many asset heavy businesses such as the ones engaged in manufacturing, power generation,iron and steel etc.

However, DuPont analysis may not be very useful for analyzing asset light businesses, such as IT, and new age online businesses, as almost all of them have very little assets but still generate large revenue.

Conclusion:

DuPont analysis is a very powerful tool to analyze the quality of a business and its ability to generate capital. It analyzes some of the most crucial factors such as what is causing the rise or decline in ROE.

If a company is able to improve its Net Profit margins without taking any additional leverage, it demonstrates that company has better pricing power over its products where consumers/ clients of the business are willing to pay higher price for the [product/service offered.

In conclusion, all I can say is DuPont analysis is a function of ROE, ands can give you great insights about the business if used with other stock evaluation and valuation frameworks.

This is a wrap on how to use DuPont Analysis to analyze companies, I hope you found this article useful and knowledgeable. Thank You for reading.    


Other Recommended Reads:
Types of Multi-Bagger Stocks and How to Spot Them
How to Build a Profitable Portfolio: A Step-By-Step Guide
Complete Guide to Fundamental Analysis of Indian Stocks
Beginners guide to Investing in Indian Stock Market 

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