Return on Equity - The DuPont Model

As you learned in the investing lessons, return on equity (ROE)

is one of the most important indicators of a firms profitability
and potential growth. Companies that boast a high return on
equity with little or no debt are able to grow without large
capital expenditures, allowing the owners of the business to
withdrawal cash and reinvest it elsewhere. Many investors fail
to realize, however, that two companies can have the same
return on equity, yet one can be a much better business.
For that reason, according to CFO Magazine, a finance
executive at E.I. du Pont de Nemours and Co., of Wilmington,
Delaware, created the DuPont system of financial analysis in
1919. That system is used around the world today and will
serve as the basis of our examination of components that make
up return on equity.
Composition of Return on Equity using the DuPont
Model
There are three components in the calculation of return on
equity using the traditional DuPont model; the net profit
margin, asset turnover, and the equity multiplier. By examining
each input individually, we can discover the sources of a
company's return on equity and compare it to its competitors.
Net Profit Margin
The net profit margin is simply the after-tax profit a company
generated for each dollar of revenue. Net profit margins vary
across industries, making it important to compare a potential
investment against its competitors. Although the general ruleof-thumb is that a higher net profit margin is preferable, it is not
uncommon for management to purposely lower the net profit
margin in a bid to attract higher sales. This low-cost, highvolume approach has turned companies such as Wal-Mart and
Nebraska Furniture Mart into veritable behemoths.

There are two ways to calculate net profit margin (for more
information and examples of each, see Analyzing an Income
Statement):
1.
2.

Net Income Revenue

Net Income + Minority Interest + Tax-Adjusted Interest
Revenue.

Whichever equation you choose, think of the net profit margin

as a safety cushion; the lower the margin, the less room for
error. A business with 1% margins has no room for flawed
execution. Small miscalculations on managements part could
lead to tremendous losses with little or no warning.
Asset Turnover
The asset turnover ratio is a measure of how effectively a
company converts its assets into sales. It is calculated as
follows:

Asset Turnover = Revenue Assets

The asset turnover ratio tends to be inversely related to the net

profit margin; i.e., the higher the net profit margin, the lower
the asset turnover. The result is that the investor can compare
companies using different models (low-profit, high-volume vs.
high-profit, low-volume) and determine which one is the more
attractive business.
Equity Multiplier
It is possible for a company with terrible sales and margins to
take on excessive debt and artificially increase its return on
equity. The equity multiplier, a measure of financial leverage,
allows the investor to see what portion of the return on equity
is the result of debt. The equity multiplier is calculated as
follows:

Equity Multiplier = Assets Shareholders Equity.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model,

simply multiply the three components (net profit margin, asset
turnover, and equity multiplier.)

Return on Equity = (Net Profit Margin) (Asset Turnover)

(Equity Multiplier).

Pepsico
To help you see the numbers in action, Ill walk you through the
calculation of return on equity using figures from Pesicos 2004
annual report. The key figures Ive taken from the financial
statements are (in millions):

Revenue: $29,261

Net Income: $4,212

Assets: $27,987

Shareholders Equity: $13,572

Plug these numbers into the financial ratio formulas to get our
components:
Net Profit Margin: Net Income ($4,212) Revenue ($29,261)
=
0.1439,
or
14.39%
Asset Turnover: Revenue ($29,261) Assets ($27,987) =
1.0455
Equity Multiplier: Assets ($27,987) Shareholders Equity
($13,572) = 2.0621
Finally, we multiply the three components together to calculate
the return on equity:
Return on Equity: (0.1439) x (1.0455) x (2.0621) = 0.3102, or
31.02%
Analyzing Your Results
A 31.02% return on equity is good in any industry. Yet, if you
were to leave out the equity multiplier to see how much

Pepsico would earn if it were completely debt-free, you will see

that the ROE drops to 15.04%. In other words, for fiscal year
2004, 15.04% of the return on equity was due to profit margins
and sales, while 15.96% was due to returns earned on the debt
at work in the business. If you found a company at a
comparable valuation with the same return on equity yet a
higher percentage arose from internally-generated sales, it
would be more attractive. Compare Pepsico to Coca-Cola on
this basis, for example, and it becomes clear (especially after
adjusted for stock options) that Coke is the stronger brand.

DuPont Models and How to Determine KPIs?

Data driven management is a popular concept and with good reason. CEOs, management teams, and
board of directors gain tremendous value in defining and managing to key performance indicators
(KPIs).
Why?
KPIs provide insight into the underlying mechanics of the business model that help teams manage
departmental functions and focus the company on the building blocks of future success. The concept
of KPIs as powerful intra-period (day, week, month, quarter) barometers of company performance is
well understood.
However, traditional mechanisms for financial management, GAAP financials and the operating plan,
are necessary, but not sufficient tools for data driven management.
Start-ups are exercises in prospective thinking and both GAAP financials and the operating plan
generally fail to provide insight into the upstream metrics that drive financial success.
GAAP financial statements are backward looking records of the past, and they often fail to provide
insights into how the company will perform in the future. Start-ups all develop operating plans,
however, in my experience 3 year plans, while necessary, are often highly abstracted summaries of a
hoped for future that tend to be more academic than operational. They tend to be the product of the
CFO's office with little day to day value for the team.
How then should one bridge the gap between GAAP financials and the high level financial
projections? As a CEO, VP, director, or individual contributor what data points matter to you? When
you come in in the morning, how do you know what to focus on with some sense of certainty that your
particular KPI is a key part of the broader company's goals?
In 1919, DuPont's F. Donaldson Brown was tasked with turning around GM after DuPont bought a
23% stake. In order to help drive clarity and transparency into the state of GM's finances, Brown
developed a model that broke down the company's ultimate goal, high return on assets, into an easy
to visualize set of critical building blocks.
The standard DuPont model follows:
Return on Equity = Net Profit Margin * Total Asset Turnover * Equity Multiplier
Each component can then be broken down into its constituent parts.
For example,
NPM = Net Income/Net Sales
TAT = Net Sales/Total Assets

EM = Total Assets/Common Equity

One can now see that higher profitability, higher asset utilization, and higher debt levels can all lead to
higher ROE. Further, each child node can be further analyzed to understand the key levers that drive
the parent node.
Net Profit Margin can be influenced by unit volume, unit price, fixed costs, variable costs, and so on.
Now, how does this apply to start-ups?
Well, start-ups can develop a custom version of the DuPont model that 1) transparently states the
formula for value creation and 2) makes visible key value-creating levers that are themselves the "Is"
in KPIs.
For example, the search business can be defined by the following formula:

Revenue is no longer an abstract

concept but a goal with clearly defined indicators that departments can execute against, such as
driving more queries per user, maximizing ad attach rates per query, optimizing click through rates,
driving higher ecpms....
A team's ability to develop a relevant DuPont model that maps out the key components of revenue
and profit is critical in developing material KPIs. To bridge the gap between Quickbooks' financials and
Excel operating plans, I suggest that a team whiteboard a model that drives both revenue and costs.
As a planning exercise:
1.

2.

develop DuPont formulas relevant to the business that define the material components of
revenue, costs, and profit
drill down on each node until there is no marginal benefit of further granularity

3.

analyze the impact of moving each indicator, or formula argument, on the desired result and
identify the most impactful indicators to manage

4.

assign each department indicators, arguments in the equation, they can control, effect,
manage, and report against

5.
6.

the formula's arguments are now the organizations KPIs

With the KPIs extracted from the company's DuPont model, data driven management is now
possible. The company, departments, and individual contributors now understand how their daily
work contributes in the aggregate to the model's efficacy
Are you struggling with identifying material KPIs? Is the operating plan a set of forecasts with
seemingly
little
relevance
to
day-to-day
operations?
If so, take the time to develop a company specific DuPont model and agree as a team on the
formula's key arguments; assign each team member a set of arguments to optimize, and come to the
team meeting with weekly snapshots and trends of the arguments' execution.
In may ways, laying out a DuPont formula is a precondition to building an operating plan, ie it
identifies the key business model drivers. Moreover, aligning strategy with a DuPont model allows for
orchestrated execution where the component pieces, ie departmental specific activities, sum to a
larger whole.