Evaluating a Business with 3-Step DuPont Analysis
.png)
Your vision is that when faced with looking at various businesses for investment opportunities, you would have more tools in your box to evaluate them.
The dilemma is you are faced with looking at various businesses as investment opportunities. What is another way outside of EBITDA/EBIT to look at comparing the businesses? You may or may not have balance sheets, income statements, and other sources to review. So what is another way to pull out the data that makes sense and can give insight into this dilemma of determining the best investment opportunity?
The case is looking at various grocery store chains to invest in and using DuPont Analysis.
A grocery store moves a tremendous amount of product, but the margin on each item this one sells is fairly low. The fastest turnover is on the basics such as milk, eggs, and produce. You would want to know the return on equity for each of the stores or chains you are comparing, so let’s work through a sample looking at one.
The solution is to look at yet another comparative tool for evaluating a business called DuPont Analysis.
Another one? Yes, this one focuses on the return on equity (ROE). This is similar to other financial analysis tools, and it’s one piece to the puzzle. Developed in 1920 by DuPont, this allows you insight into what financial activities affect the ROE changes. For the purpose of this article, we are looking at the 3-step DuPont Analysis vs. the 5-step. A drawback to keep in mind is that there isn’t any explanation as to why ratios are high or low and what the reference range should be.
ROE is made up of these three main components:
ROE = Net Profit Margin X Total Asset Turnover X Leverage
1. Net Profit Margin = Net Income / Sales
This looks at the operations, or the profit compared to the total sales, and the higher the number, the better. Net income and sales are both found on the incomes statement. After deducting the cost of inventory, labor, taxes, and other expenses, the grocery store makes $.08 for every dollar, which would be $.08 / $1.00, so their net profit margin is 8%.
How would you improve the net profit margin? Cut expenses, increase the price, or change up the products and services in the portfolio. Groceries tend to be price-sensitive, lower-margin, only higher-margin if there are specialty types of products, so is there a way to check out other suppliers for more cost-effective bulk purchasing power? Maybe it makes sense to switch suppliers to improve this. What about changing up the product mix and adding in some higher-margin gourmet selections?
2. Total Asset Turnover = Sales / Total Assets
This also looks at operations, and the higher the number, the better. Note that you should take the industry into account when reviewing Net Profit Margin and Total Asset Turnover because price, equipment required, etc., to order affects the turnover. Most often a business either has a high net profit margin or high asset turnover. In our case, a grocery store is likely to have a higher total asset turnover due to the nature of the business. To keep the numbers simple, you could think of it like the grocery chain having $100,000 in assets, and they made $200,000 in revenue, that would be $200,000 / $100,000, an asset turnover ratio of 2.
How would you improve total asset turnover? Reduce the receivables, inventory, cut down on fixed asset spend, or increase the payables payment terms. Could the grocery chain reduce the fixed asset spend when it comes to land requirements by ordering online? This may reduce the need for such extensive displays if customers choose online, and a portion of the store could be more of a warehouse design.
3. Financial Leverage = Total Assets / Total Equity
This one shows you the financial activities. If this is higher, then it can be viewed as a higher risk of default because this is the debt used by the company compared to the equity (look for equity on the balance sheet. It’s the value a business could retrieve from selling all the assets and paying off the debt). In the case of the grocery chain, you would want to watch for high debt because that is likely for interest payments, and when sales dip, there is a likelihood for bankruptcy. To again keep the numbers simple, let’s say the grocery chain has $100,000 in assets and $50,000 in equity, so $100,000 / $50,000, that equals 2.
How would you improve financial leverage? Buy back some of the shares, pay dividends, or pay off debt.
The end goal is to either use these figures to compare to like businesses in the case of an investor or look to raise the ROE through keeping a high-profit margin, increasing asset turnover, or leveraging assets better. This formula allows you to find the area that needs improvement.
The ROE of this grocery chain is as follows:
ROE = Net Profit Margin X Total Asset Turnover X Leverage
ROE = .08 X 2 X 2
ROE = .32 or 32%
Try this out with your own example, and then start looking at it by year to see what the trend looks like over the course of 3 to 5 years.
Written by Nicole Hullihen, July 5th, 2021
Learn more about how I can help.
References recommended if you would like to learn more on this topic:
Accounting Tools. (2021, Jan 7). DuPont Analysis Definition. Accounting Tools. Retrieved from https://www.accountingtools.com/articles/dupont-analysis.html.
Corporate Finance Institute. (n.d.). DuPont Analysis. CFI Education Inc. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/dupont-analysis/.
Fernando, J. (2021, Feb 27). Equity. Investopedia. Retrieved from https://www.investopedia.com/terms/e/equity.asp.
Hargrave, M. (2021, Mar 16). DuPont Analysis. Investopedia. Retrieved from https://www.investopedia.com/terms/d/dupontanalysis.asp.