Du Pont identity

DuPont Analysis (also known as the dupont identity, DuPont equation, DuPont Model or the DuPont method) is an expression which breaks ROE (return on equity) into three parts.

The name comes from the DuPont Corporation that started using this formula in the 1920s. DuPont explosives salesman Donaldson Brown invented this formula in an internal efficiency report in 1912.

ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity) = (Net Profit/Equity)

The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries).

The Du Pont identity is less useful for industries such as investment banking, in which the underlying elements are not meaningful. Variations of the Du Pont identity have been developed for industries where the elements are weakly meaningful.

Other industries, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may be critical. The Du Pont identity allows analysts to determine which of the elements is dominant in any change of ROE.

Certain types of retail operations, particularly stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under-, or, over-performance. For example, same store sales of many retailers is considered important as an indication that the firm is deriving greater profits from existing stores (rather than showing improved performance by continually opening stores).

Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. Other industries would see high levels of leverage as unacceptably risky. Du Pont analysis enables third parties that rely primarily on their financial statements to compare leverage among similar companies.

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