Using the Dupont approach to analyzing a company’s Return on Equity provides an investor with valuable information about where it is that their return is coming from. By breaking down RoE into as many as five component aspects, we can see how it is that changes in each individual aspect can be of benefit or detriment to an investor’s portfolio. In this article, we are going to discuss how it is that the five part Dupont formula will show us a complete picture of where it is that a company’s returns can come from, and then discuss how it is that we can interpret the results from the perspective of a personal investor.
The five part Dupont formula differentiates itself from the three part in the way that it demonstrates the impacts of taxation on a company’s profitability, and then explicitly shows how it is that interest payment and coverage can also impact this profitability. The rationale here is that a company with a higher tax rate will have fewer funds available to pay out to investors than if it were operating in a lower tax environment. From there, the interest coverage ratio provides investors with additional information about the leveraged position of the company. If a company has access to cheaper debt capital than its competitors, than it will arguably be able to pay out more funds to investors than it would otherwise.
The five part Dupont model is calculated by multiplying a company’s tax burden, interest burden, EBIT margin, asset turnover, and financial leverage ratios all together. From here, we can look at how it is that the subject company’s profitability, solvency (ability to cover interest payments), efficiency, and its risk exposure all generate financial returns for investors.
When examining the five-part model, we want to start looking at how it is that the different components relate to each other. For example, while a high degree of leverage is generally unfavorable, it can be counter-balanced by a high interest coverage margin if the company has reasonably sustainable revenues. Additionally, we’d want to look at how it is that the interest burden measures up against the tax burden, to see if the company is paying a particularly large amount of taxes. If taxation is the greatest resistance to increase returns, we need to evaluate the political regime that is in the company’s jurisdiction, and determine if there are any additional political risks that might follow. Lastly, we can evaluate how it is that the subject company’s asset turnover compares to its leverage.
