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ROE DuPont Analysis - How to Use the DuPont Equation to Analyze a Stock - DuPont Decomposition - YouTube
Channel: Learn to Invest - Investors Grow
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return on equity is one of the few
ratios that ignores the price of the
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stock so what does return on equity
actually tell us well it can tell us a
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lot if we look close enough and this is
where the DuPont analysis comes in in
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the DuPont analysis we break down return
on equity this break down helps us see
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the impact of profit margins leverage
and turnover on shareholder returns
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let's look a bit closer the calculation
for return on equity often called ROE
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for short is simply net income divided
by equity so this tells us how much
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profit a company generates for each
dollar of equity so a return on equity
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of 25 percent tells us that for every $1
of equity the company generates 25 cents
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in profit but how return on equity is
generated can often help add to the
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story so essentially the DuPont analysis
is a breakdown of this formula to look
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closer at how ROE was generated
here's an example of an income statement
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and a balance sheet so if we simply take
net income and divided by the average
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equity we see that we get a return on
equity of 32% now you may notice that we
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simply use net income and we had to use
average equity not just equity and
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that's because net income is the income
earned over the entire year while equity
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and the balance sheet as a whole is
simply a snapshot at a specific point in
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time in this case the end of 2017 so to
make the two numbers comparable we
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typically use averages on the balance
sheet so we add up the starting number
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which is the ending number from last
year to this year's ending number and we
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divide by 2 simple enough now let's
start breaking this down if we take net
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income and divide it by revenue we get
net profit margin but then we can take
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revenue and divided by the average total
equity and this gives us our equity
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turnover net profit margin tells us what
percentage of revenue is converted to
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profit equity turnover measures how much
revenue the equity is able to generate
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over the course of the year but we can
go further we break equity turnover down
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by adding average total assets so now we
have net profit margin asset turnover
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and a leverage ratio this allows us to
see how the equity turnover was created
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and how it contributed to over
return on equity asset turnover helps us
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examine how effectively management uses
the assets to generate revenue this
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leverage ratio shows us how much the
company borrows or how leveraged they
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are because don't forget the basic
formula of the balance sheet its assets
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equals liabilities plus equity so if
there were no liabilities
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well then assets and equity would be the
same and our leverage ratio would be one
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so the more debt the company has the
higher this ratio will be now if we
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stopped right here this formula was the
original version of the du Pont equation
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but it was realized that the net profit
margin formula can be further
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deconstructed to give us even more
information instead of going right from
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net income to revenue we could break
this into tax burden which shows us the
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effects of taxes on profit interest
burden which shows us the effects of
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interest expenses and finally operating
margin which shows us the percentage of
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profit from operating the business now
if we simply multiply these numbers we
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end up with the exact same 32% we
calculated to start with now we could do
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the same DuPont decomposition to a
competitor in the same industry to
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analyze not just how return on equity
stacks up but why they're different we
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could also compare a company to its own
history why has ROE changed since we
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had the last few years in numbers here
let's take a look at the changes so in
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2015 ROE was a hundred and one
percent in 2016 it fell to 73% in the
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calculation we already saw in 2017 it
was just 32 percent when we look closer
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we can see of the tax burden fell which
is negative for ROE all these
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percentages here the closer they are to
a hundred percent the less impact they
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have on ROE so the 50% we can see
that taxes took a huge chunk out of
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earnings before taxes
then interest burn got slightly worse
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each year by the looks of it it seems
that EBIT was falling faster than
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interest expenses were falling
then we have operating margin and that
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got worse as well suggesting a less
efficient business now we can also see
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that asset turnover is falling which
tells us that a hundred dollars in
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assets let's say in 2015
produce seventy two dollars in revenue
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now it's only producing sixty five
dollars in revenue
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generally higher financial leverage
leads to a higher return on equity and
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this makes sense because if a company
had a ton of debt well this would lead
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to a smaller equity which in turn would
create a higher return on equity so we
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usually want to be careful if we see
return on equity improving but then we
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noticed that it is due to an increase in
financial leverage this can be a red
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flag about the company so that's an
example of the DuPont equation and how
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we can use a DuPont equation to
determine what is happening to return on
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equity if you have any questions about
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