DuPont Analysis : A systematic way of stock picking

In a market where complacency levels may falter any time thanks to central banks’ moves, geo-political concerns and overvaluation issues, picking the right stock is a challenge. The metric return on equity goes a long way in resolving this issue.

The metric enables investors to differentiate between a profit-churner and a profit-burner. It is a profitability ratio that measures the earnings that a company generates from its equity.

But to fine-tune this basic concept, one can land on DuPont analysis. This theory will take investors a step higher and better pick some quality stocks. The DuPont method analysis acts as a key technique for analyzing the performance of companies to invest in.

Are you in the dark regarding your investments?What do you look for in a company before investing in it? Industry prospects. Management credentials. Information about its products. Market share and competitors. Profit margins and financial ratios. Right?
Most of us work through such a checklist of criteria to pick stocks to invest in. This systematic scrutiny gives us a satisfying feeling that we have thoroughly researched these companies.Is this sufficient evidence to commit you to a investing in a stock? We believe not.There may still be some loopholes which might have been overlooked.

Shedding light through the DuPont Method
The DuPont method will enable you to unearth facts that are not so obvious, and so lead you to making more informed and better investment decisions.The DuPont analysis was developed by DuPont Corporation in the 1920s. It is a performance measurement technique to better understand Return on Equity (ROE). RoE is an important ratio that tells us how much wealth a company can potentially generate for its shareholders.
Return on equity (ROE) is one of the top ratios that investors use to screen profitable stocks. However, delving into the basic ROE and analyzing it at a deeper level, with the help of DuPont analysis, could lead to better returns.
It is an analytical method, which critically examines three major elements – operating management, management of assets and the capital structure – related to the financial condition of a company. It’s basically taking ROE apart to examine how it works. Although it can be presented in several ways, the most popular one is shown below:

ROE = Net Income/Equity

Net Income / Equity = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity)

ROE = Profit Margin * Asset Turnover Ratio * Equity Multiplier.

Why Use DuPont?

The importance of ROE can’t be denied but still it doesn’t always provide a complete picture.The DuPont analysis, on the other hand, allows investors to assess the elements that play a dominant role in any change in ROE. It can help investors to segregate companies having higher margins from those having high turnover. For example, high end fashion brands generally survive on high margin as compared with retail goods, which rely on higher turnover.
In fact, it also sheds light on a company’s leverage status, which can go a long way in selecting stocks poised for gains. A lofty ROE could be due to the overuse of debt. Thus, ROE of a company can be misleading if it has a high debt burden.

So, an investor confined solely to an ROE perspective will be at a loss if he or she has to judge between two stocks of equal ratio. DuPont analysis comes to the rescue and finds out the better stock. Thus, a company with a healthy mix of all the three metrics – profit margin, asset turnover ratio and equity multiplier – will be the most alluring.

DuPont analysis is not difficult, as the required numbers are available in a company’s income statement and balance sheet.

What Is DuPont Analysis

DuPont Analysis is a method of performance measurement that breaks down Return on Equity into three parts; Net Margin, Asset Turnover Ratio and Equity Multiplier.It tells us how much of the ROE is due to leverage, operating profitability and asset turnovers.
The formula is as follows;

Return on Equity (%) = Net Margin x Asset Turnover Ratio x Equity Multiplier

Where (expressed in %);

• Net Margin = Net Income / Revenue
• Asset Turnover Ratio = Revenue / Total Assets
• Equity Multiplier = Total Assets / Shareholder’s Equity

Net Margin is the earnings after all expenses, taxes, interests and dividends are paid out in relation to revenue. It tells us how profitable a company is.
The Asset Turnover Ratio measures a company’s effectiveness in is using its assets to generate revenue. A higher percentage means a better performing company.
Lastly, the Equity Multiplier measures financial leverage. A higher percentage suggests a highly leveraged company.
This DuPont analysis examines RoE (Net Profit/Equity) through three components which are:

Operating efficiency, measured by profit margin (Net Profit/Sales)
Asset use efficiency, measured by total asset turnover (Sales/Total Assets)
Financial leverage, measured by the equity multiplier

Put in equation form,

RoE (Return on Equity) = (Net profit margin) * (Asset turnover) * (Equity multiplier) OR

RoE = Net Profit/ Equity = (Net Profit/ Sales) *(Sales/Total Assets) * (Total Assets/Equity)

Through our investigation of RoE using the DuPont method, we have the advantage of getting a detailed picture of which component has contributed the most (and the least) to the company's RoE. This in turn will tell us if the company has sound fundamentals, and if it can sustain its performance in the long run. The DuPont equation also allows the analyst to see the overall strategy and key drivers for a company. And, if a company's ROE is unsatisfactory, the DuPont analysis helps locate that part of the business that is underperforming.

DuPont Analysis - An Example

An hypothetical example aids us in grasping the value of the DuPont model. Consider two companies, company A and company B, each with a RoE of20%. Prima facie (or At first glance), they look like equally attractive investments. Now, we can delve deeper by using the DuPont analysis:

RoE = (Net profit margin) * (Asset turnover) * (Equity multiplier)

For Company A: RoE (A) = 31% * 0.1* 6.5

For Company B: RoE (B) = 16% * 1.0* 1.2

We observe that even though both the companies generate the same RoE, their inherent components are very different, and so communicate unique information regarding the company.

RoE of company A at 20% is mainly because of the high net profit margin (of 31%) and huge financial leverage (of 6.5) that the company has. While a high net profit margin is desirable, financial leverage should be optimum and not so high. For company B, even with a lower (lower than company A) net profit margin of 16%, it is able to generate an RoE of 20% as a result of its high asset turnover ratio which is fine.

While the DuPont method highlights key strategic aspects of the companies, it also raises important questions. For instance, why is Company A's profit margin so high? And is that sustainable? Also, why does Company A have so much debt on its books?

For Company B, an obvious question is "is its profit margin in line with that of the sector".

Clearly, the DuPont method, through what it highlights, and the questions it raises, provides insights into these company's strategies and operations, in a way that is not evident from just knowing their 20% RoE. This is the power of this analysis.

Moneycontrol did a DuPont analysis of its own to pick out stocks that checked all our parameters -- an increasing operating profit margin, an increasing asset turnover, and a decreasing asset-to-equity ratio.

Picking stocks to invest in could be tricky at times, particularly when there are tips flying around left, right and centre. There are many aspects one must ideally consider before settling on a scrip to invest in because rushing in blindly to where the light is shining the brightest may not always pay off.

A DuPont analysis is one of the most apt indicators to go by when it comes to picking stocks because it gives you the exact return on equity (RoE) for a particular stock. In order to do so, it combines three of the most important parameters that pertain to the profitability of a company -- operating profit margin, operational efficiency (based on total asset turnover), and financial leverage (based on ratio of total assets to equity).

However, a DuPont analysis is only a tool of measure and does not exactly spell out which stock is worth investing in. In order to do so, Moneycontrol did a DuPont analysis of its own to pick out stocks that checked all our parameters -- an increasing operating profit margin, an increasing asset turnover, and a decreasing asset-to-equity ratio.

An increasing operating profit margin indicates that a company is making more today for the same amount of products sold than it was making earlier, while an increasing asset turnover is indicative of improving profitability of a company as a whole. A decreasing asset-to-equity ratio indicates that a company is less dependent on debt than it was before.

Although there are many companies who reported an increase in their return on equity over the last three years, only 15 managed to do so while meeting all three above-mentioned criteria. And not surprisingly, 13 of these stocks have returned between 100 and 970 percent over the last three years.

Among these 13 stocks, COSYN, Maithan Alloys, Associated Alcohols and Vakrangee led the pack with gains of over 550 percent.

Of the 15 companies that passed our filters, there were four IT companies -- 8K Miles Software Services, COSYN, Onward Technologies and Vakrangee -- and three auto ancillary companies -- GP Petroleums, Harita Seating Systems, Investment & Precision Castings.

Final Thoughts

Return on Equity is one of Warren Buffett’s favorite number when it comes to finding good investments. A company with a durable competitive advantage exhibits consistent high returns on equities.But not all companies with high returns are good companies.

By using DuPont Analysis, we can carefully single out these types of companies that are highly leveraged compared to those that are really profitable.

If you find a company that shows consistent high returns on equities, use this method to take a different approach. That way, you’ll make a better investment decision.

Try this out to your long-term investments to see if you are really investing in a company with a competitive advantage.

Happy investing!

Next Read : Dhanlaxmi Bank : A Turnaround Banker
Previous Read :South Indian Bank-All set for big leap