Model Answer
0 min readIntroduction
Return on Equity (RoE) is a crucial financial ratio that measures a company’s profitability relative to shareholder equity. It indicates how efficiently a company is using its shareholders’ investments to generate profits. However, a simple RoE calculation doesn’t reveal *how* that return is being generated. The DuPont analysis, developed by the DuPont Corporation, breaks down RoE into its component parts – profit margin, asset turnover, and financial leverage – providing a more insightful understanding of a company’s performance. This analysis helps investors identify the key drivers of RoE and assess the sustainability of profitability.
Understanding the DuPont Analysis
The DuPont analysis expresses RoE as a product of three ratios:
RoE = Net Profit Margin x Asset Turnover x Equity Multiplier
- Net Profit Margin: Measures how much profit a company generates from each dollar of revenue (Net Income / Revenue).
- Asset Turnover: Measures how efficiently a company uses its assets to generate revenue (Revenue / Total Assets).
- Equity Multiplier: Measures the extent to which a company uses debt financing (Total Assets / Shareholder Equity). It reflects financial leverage.
Hypothetical Company Data
Since the question doesn’t provide company data, let’s consider two hypothetical companies, Alpha and Beta, with the following financial information (figures in millions):
| Financial Metric | Company Alpha | Company Beta |
|---|---|---|
| Net Income | $10 | $15 |
| Revenue | $100 | $120 |
| Total Assets | $50 | $60 |
| Shareholder Equity | $25 | $30 |
DuPont Analysis Calculation
Let's calculate the DuPont components for both companies:
Company Alpha
- Net Profit Margin = $10 / $100 = 0.10 (10%)
- Asset Turnover = $100 / $50 = 2.0
- Equity Multiplier = $50 / $25 = 2.0
- RoE = 0.10 x 2.0 x 2.0 = 0.40 (40%)
Company Beta
- Net Profit Margin = $15 / $120 = 0.125 (12.5%)
- Asset Turnover = $120 / $60 = 2.0
- Equity Multiplier = $60 / $30 = 2.0
- RoE = 0.125 x 2.0 x 2.0 = 0.50 (50%)
Comparative Analysis
The results show that Company Beta has a higher RoE (50%) compared to Company Alpha (40%). This difference is primarily driven by a higher net profit margin (12.5% vs. 10%). Both companies have the same asset turnover and equity multiplier, indicating similar efficiency in asset utilization and financial leverage.
A higher profit margin suggests that Company Beta is more effective at controlling its costs and/or has a stronger pricing power. While both companies are utilizing their assets and debt similarly, Beta’s superior profitability translates into a better return for shareholders.
However, it's important to note that a high equity multiplier (and therefore high leverage) can also increase risk. In this case, both companies have the same multiplier, so this isn't a differentiating factor. Further analysis would be needed to assess the sustainability of these margins and the overall risk profile of each company.
Conclusion
Based on the DuPont analysis, investors would likely prefer Company Beta. Its higher RoE, driven by a superior net profit margin, indicates a more profitable and efficient operation. While both companies demonstrate similar asset utilization and financial leverage, Beta’s ability to generate more profit from each dollar of revenue makes it a more attractive investment. However, a comprehensive investment decision would require a deeper dive into the companies’ industry, competitive landscape, and future growth prospects.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.