Margin, Efficiency, and the DuPont Formula - Part 2

In Part 1, I reviewed 8 companies with a wide range in both margins and profitability and showed that high margins do not always translate into high profits.  The explanation for these profitability variations lies somewhere other than with margin.  However, comparing different companies is challenging.  There are many aspects that must be considered.  That's where the DuPont Formula can be helpful.

Developed in the 1920's by the chemical company DuPont, it takes the Return on Equity ratio and expands it.  It attempts to answer why company A's Return on Equity (ROE) is different than company B's.

Return on Equity is simply profit divided by shareholders' equity, where equity is the value of the company as measured by its assets (what it owns) minus its liabilities (what it owes).  ROE is a measure of how efficient a company is at generating profits from its investors' equity.

Looking at two of the companies from Part 1, Rogers has an ROE of 38.6% but Bell's ROE is less than half that at 15.0%.  At first glance this is surprising, given they are both in the same industry, have similar margins, and have similar net income per share.  Why should their ROE be so different?

The DuPont Formula, Step 1

The DuPont formula expands the ROE ratio into 3 parts.

The first ratio in this expanded equation is simply the profit margin, or the margin when all types of expenses are included.  In Part 1, we only looked at Operating Margins.  It turns out the net Profit Margins for Rogers and Bell are also similar (12.5% and 12.0% respectively).

Asset turnover is the rate at which the company's assets generate sales, which is really the only reason for having assets.  A turnover of 1 means the assets generate an equal amount of sales every year. 

The equity multiplier is a measure of financial leverage, or the amount of debt being used by the company.  Assets can be purchased either by using shareholder equity or by using loans.  Because Assets = Liabilities + Equity, a higher proportion of loans (i.e. liabilities) means a lower proportion of equity, and therefore a higher ROE.

Plugging the numbers into the formula, we get the following:

Company	ROE	Profit Margin	Asset Turnover	Equity Multiplier
Rogers	38.6%	12.5%	0.70	4.38
Bell	15.0%	12.0%	0.46	2.72

It is clear that while Rogers and Bell are similar in profit margin, they are very different in asset turnover and leverage.  Rogers generates a much higher rate of sales given its assets, and it also uses a lot more debt relative to Bell.

The DuPont Formula, Step 2

The formula can be expanded further, providing more information about the profit margin ratio.  Instead of 3 separate component ratios, there are now 5.

The profit margin is now split into 3 components of its own.

Net Profit over Pretax Profit measures the company's tax burden, typically something that the company has very little control over.  It is dependent on the jurisdiction that it operates in, and other regulatory costs that governments sometimes impose on certain industries.

Pretax Profit over  Earnings Before Interest and Taxes (EBIT)  is the interest burden, a measure of both the amount of debt and the interest rates the company is charged.  This is largely within control of the company, and it is related to the leverage ratio.  While more debt potentially increases return on equity by permitting the purchase of additional assets, it also increases the interest burden which in turn lowers return on equity.

Finally, EBIT over Sales is a measure of the ability of the company to generate earnings, including non-operating revenues, given the amount of sales they have.

Plugging in these numbers, we get the following:

Company	ROE	Tax Burden	Interest Burden	EBIT/ Sales	Asset Turnover	Equity Multiplier
Rogers	38.6%	0.71	0.76	23.0%	0.70	4.38
Bell	15.0%	0.80	0.80	18.7%	0.46	2.72

In the first table, Rogers and Bell had similar profit margins (12.5% and 12.0% respectively), with Rogers being slightly better.  Now that measure is shown as three components, we can see that Rogers' lead is not due to lower taxes (they pay slightly more than Bell as a ratio) and it's not due to lower interest payments (they pay more than Bell), but it's due to their better ability to generate earnings relative to their sales.

The DuPont Formula has taken that single ROE measure and split it into five different components that tell a much more detailed story about these two similar companies.