DuPont Analysis

DuPont de Nemours, Inc. (NYSE: DD) operates as a holding company developing specialty materials, chemicals and agricultural products. The company is headquartered in Wilmington, Delaware and currently has 23,000 full-time employees.

We have updated the company’s rating based on the results of the new quarterly report:

This company has not been our favorite in recent years, reaching at most only half of the benchmark by which we measure the attractiveness of each business.

The price chart seems to hint that our assessment turned out to be fair, because over the last 5 years the result of investments in DD would have been negative.

And for the quarter that ended in December 2023, the corporation reported a loss of 22 million US dollars, which practically eliminated the net profit margin and return on equity, which serves as a measure of the company’s efficiency in our algorithm.

So, why are we writing about this not particularly remarkable company and its “successes”?
The thing is that it was this company that in the 20s of the last century developed an approach and formula for assessing the efficiency of a business through various factors influencing it.
This method or model was subsequently called DuPont model or analysis. It had a strong influence on the formation of our algorithm in particular, and also, probably, nothing better has been invented yet to illustrate how important return on equity (ROE) is when evaluating any business.

So what do we know about ROE? The classic formula says that this is the net profit to the equity ratio. And this ratio is needed to understand how much net profit the company earns per unit of its own funds. It’s simple.

But the laws of mathematics allow any ratio to be multiplied and divided by the same value. This will not change the meaning of the equation, but the understanding may expand. This is what DuPont analysts did, namely Donaldson Brown, who is the author of this approach.

To begin, Mr. Brown added assets to both the numerator and denominator. The two-factor model assumes that return on equity is the product of return on assets and the asset-to-equity ratio or financial leverage. What is the mathematical meaning of this, you ask? The fact of the matter is that there is no mathematical meaning. But let me show you one company:

This is Apple Inc (AAPL). DuPont 2-step analysis is visually implemented inside the company page on eyestock. We see a return on assets (ROA) of 29% over the last 12 months and a financial leverage ratio (assets divided by equity) of 5.3. What is financial leverage? Financial leverage is a multiplier that shows how much of a company’s assets are financed by debts and other liabilities assumed. The higher the value of this indicator, the more often the company resorts to borrowing to purchase new assets.
The median value of financial leverage for AAPL over the last 3 years is 5.44, which means that the company is quite aggressive in its use of debt capital. For every dollar of its own assets, it attracts 5 borrowed ones. It is by using the product of ROA and the median of financial leverage that we calculate ROE for a company. For what? For a deeper understanding. 158% ROE is a very high lelvel. But now we understand how it is achieved. Due to 29% return on assets and x5 leverage!

In addition, we often hear that our company valuation model does not take into account ROA. Whatever the case! Now you know that return on assets is an integral part of return on equity!

Following the same logic, Mr. Brown and the DuPont company arrived at a 3-step formula that now represented return on equity as the product of return on sales, asset turnover rate and financial leverage.
And the 5-step analysis looks like this:

What is this all for? To understand what affects business efficiency and by influencing which metric you can manage business performance. According to this formula, ROE includes: tax and interest burden, operating margin, asset turnover and financial leverage.

If you are just starting your journey in financial analysis, then spend some time studying these models. ROE is the cornerstone of the valuation of almost any business, and for over 100 years, thanks to DuPont and Donaldson Brown, it has given us five ratings instead of one!