What is DuPont Analyses?.

Well it sounds like a fancy word, the kinds you would use to impress the non finance audience. It has an air of complexity to it which creates Expert Bias in the mind of the listener at least.

Value investors sniff the pedigree (breed) of their fellow investors by the words and jargon they use and DuPont analyses is right up there, probably below ‘Moat’ and ‘Owners Earnings’.

So what is it??

Brief history is that in 1920s, there use to be a big corporation by the name of DuPont and they devised a new way of measuring performance. Assets measured at their gross book value instead of net value.

Essentially DuPont analyses says that Return on Equity can be affected by 03 things.

Operating efficiency. Which can be measured by calculating the Profit Margin (profit/sales),

Asset Efficiency (Which is Total Asset turnover or (Sales/Assets),

and Leverage (which is equity multiplier or (Assets/Equity)

 

So the formula is

ROE = Profit margin * Total Asset Turnover * Equity Multiplier. (Better to take the average for the latter 02 items as these are balance sheet items)

 

 

Why is it important. It breaks down the Return on Equity and therefore you know the difference between a company which is earning Awesome ROE because they are leveraged Vs a company whose ROE is great (a touch below awesome BUT they are not using leverage).

Of course the second company is a better investment. As we have all seen, when the tide of economic cycle turns, the most levered company (swimming naked) are the ones who get exposed.

Second important factor that DuPont teaches us is that huge profit margin is not the only way to have great ROE, HUGE asset turnover can also result in great Return on equity numbers.

Walmart has great ROE despite having paper thin margins because of their ability to run a very tight ship and their inventory turnover is huge. (Warren admittingly missed it, left sucking the thumb while it multiplied)

Amex has a great ROE because of huge margins. They may sell less, but when they do, boy do they make it count and that their business is sticky.

DuPont basically teaches us a couple of things. A) Do not get impressed by high ROE, see the amount of leverage used.

And B) There are 02 ways (actually 03 if you include leverage) to enhance efficiency either by increasing margins or by increasing asset turnover. So a low margin player can be a BIG moat too. In-fact a bigger moat as no one can compete with them over peanuts, and they get to keep those peanuts. And all those peanuts combined make a BIG Juicy Snicker Bar.

Moat as they call it, is in company’s ability to maintain that edge. Either of profit margin or of running a tight ship with cost cutting. And that edge can be Psychological or physical or both. (great customer service, amazing distribution etc)

Now that was easy wasn’t it, now go ahead and flaunt around and use the word DuPont this and Moat that, and impress the opposite gender. Cheers!!!