Automated Return on Equity Analysis with the Dupont Formula

Published: April 27, 2016 at 7:15 am

The 10th version of the freefincal automated stock analyzer includes an easy-to-understand graphical analysis of the factors that drive return on equity (ROE) using the five-step Dupont Analysis.

Return on equity is defined as

ROE = Net income/shareholders equity.

It is the profit for each unit of shareholders equity or the earning power of the company. If there is a gradual increase or decrease in ROE, it is beneficial to dig deeper and find out the reasons behind the trend.

Deconstructing the ROE into multiple factors helps us understand the factors that drive the ROE change. This was first done by DuPont explosives salesman Donaldson Brown in 1912 and hence the name Dupont formula.

In its modern form, the ROE is written as a product of five ratios.

ROE-formula

Thus the ROE is the product of

  1. Financial leverage
  2. asset turnover
  3. operating margin
  4. interest burden
  5. tax burden.

1. The financial leverage is a measure of a companies debt. Higher the leverage, higher the borrowing and it could result in an increase in ROE! Therefore, if a fall in ROE is driven by a fall in financial leverage it is probably a good development.

2. Asset turnover is a measure of how well assets (including debt) are used to generate profit. An increase in ROE coupled with an increase in asset turnover is desirable. Decreasing asset turnover but steady/increasing revenue could imply the presence of unproductive assets.

3. Operating margin can be thought of as the profit left over after paying for production costs. A healthy operating margin is necessary to pay back debt. An increase in financial leverage should soon result in an increase in operating margin!

4. Interest burden represents the extent interest that has to be paid out to lenders. When financial leverage increases, interest burden will also increase.

5. Tax burden is a measure of the taxes that has to be paid. When interest burden increases, tax burden will usually decrease.

As with all financial ratios and balance sheet entries, these are heavily industry dependent.

Here is an example screenshot (click to enlarge) of the Dupont analysis page. The financial data is automatically downloaded from Morning Star.

dupon-analysis-Bharti-Airtel
Dupont Analysis of Bharti Airtel

The ROE has dropped significantly.  The main ROE driver appears to be a fall in operating margin and net income. However, financial leverage has increased and therefore so has the interest burden.

The operating margin seems to have picked up last FY which is important considering the higher interest burden. While I do not know the reasons behind the fall, there are indications of a recent increase in profitability. Excuse me if this is not a very effective example for demonstrating ROE drivers, I am only a student. In any case, I had a wonderful time trying to understand about ROE drivers behind Colgate, Berger, Emami  and other companies.

Other Features

The automated stock analysis sheet

  • pulls financials from morningstar and analyzes them
  • pulls adjusted stock price history from money control, and
  • calculates intrinsic value six different ways!

It also pulls annual (standalone/consolidated) and quarterly financials from Value Research online.

Valuation models available:

1) Price Multiple Model

2) Sustainable Growth Rate

3) Book Value Growth Rate (Buffett’s approach to valuation)

4) Discounted Cash FlowOpens in a new windowOpens in a new window (DCF) 

5) Reverse DCF Valuation

6) Graham formula  and Graham number

7)  Piotroski Score for the last 9 financial yearsOpens in a new window

8) Earnings Growth Estimate.

Download version 14th of the freefincal stock analyzer June 16th, 2019 <== latest!

Do share if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps