The DuPont identity, a widely used technique in finance, is an expression which breaks a company´s return on equity (ROE) down into three parts and shows how it is the product of three other ratios:
- The profit margin. The profit margin measures operating efficiency.
- The total asset turnover. The total asset turnover measures asset use efficiency.
- The equity multiplier. The financial leverage is measured by the equity multiplier.
This concept DyPont identity is also known as the DuPont analysis, the DuPont equation, the DuPont frameworkd, the DuPont model, and the DuPont method. It is named after the DuPont company. In 1912, the DuPont explosives salesman Frank Donaldson Brown came up with the formula for an internal efficiency report, and in the 1920, the company began using it more extensively.
Why use DuPont identity?
When ROE is unsatisfactory, the DuPont identity can help the company management (and third-party analysts) better understand which part of the business that is underperforming and needs to be adjusted.
The formula for the DuPont identity
ROE = profit margin x asset turnover x equity multiplier
ROE = (net income / sales) x (revenue / total assets) x (total assets / shareholder equity)
This is the financial data reported by Company XYZ for the previous two years:
- Net income = $180,000
- Revenues = $300,000
- Total assets = $500,000
- Shareholder equity = $900,000
- Net income = $170,000
- Revenues = $327,000<
- Total assets = $545,000
- Shareholder equity = $980,000
The ROE for Year 1:
($180,000 / $300,000) x ($300,000 / $500,000) x ($500,000 / $900,000) =
0.6 x 0.6 x 0,56 = 0, 2016
The ROE for Year 1 is 20%
The ROE for Year 2:
($170,000 / $327,000) x ($327,000 / $545,000) x ($545,000 / $980,000) =
= 0.52 x 0.6 x 0.56 = 0.1747
The ROE for Year 1 is 17%.
Anyone analysing this company can see that ROE is lower for the second year compared to the first year. By looking closer at the DuPont identity, we can break down where the decline is happening, and which areas that need attention. During year 2, revenues went up, so what is wrong?
Looking at the DuPoint identity, we can see that the total asset turnover and the equity multiple remained constant. Therefore, the change has happened in the profit margin. We look at the profit margin, and see that it dropped from 60% to 52%, despite the increased revenues. This indicates that we should look for issues pertaining to how the company has handled its costs in year two.
About the inventor
As mentioned above, the DuPont identity formula was created by Fran Donaldson Brown who was employed by the DuPont Company.
Born in 1885, Brown did his graduate studies in engineering at Cornell University, before being hired as an explosives salesman for DuPont in 1909. In 1912, he caught the attention of DuPont´s treasurer John J. Raskob who brought him into the financial part of the company and encouraged him to evaluate DuPont´s diverse business interests. It was then that Brown came up with the DuPont identity formula.
In 1918, Brown assisted with DuPont´s purchase of a large stake in General Motors. Later that same year, Brown was appointed treasurer of DuPont, and in 1921 he was appointed treasurer of General Motors to help product DuPont´s investment. From 1924, Brown was a part of GM´s executive board, serving as vice chairman in 1937-1946.