DuPont Analysis

Analysis of Return on Stockholders Equity & Investment (ROE & ROI)

The DuPont Equation [Return on Equity (ROE)]

NI ROE Equity

The DuPont Equation [Return on Equity (ROE)]

NI Sales Assets NI ROE X X Sales Assets Equity Equity ROE ( profitability ) X (efficiency ) X (leverage)

The DuPont Equation [Return on Equity (ROE)]

NI ROE Equity NI Sales Assets ROE X X Sales Assets Equity

ROE ( NPM arg in) X (TATR) X ( EquityMult iplier) ROE ( profitability) X (efficiency X (leverage) )

DuPont System of Analysis ROE Equation

The firm's ROE is broken into three components: A profitability measure (net profit margin) An efficiency measure(total asset turnover) A leverage measure (financial leverage multiplier) In other words, the Du Pont system focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (EM) It shows how these factors combine to determine the ROE.

Interpretation of Du Pont System

If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the company. However, if the equity multiplier is the source of the rise, and the company was already appropriately leveraged, this is simply making things more risky. If the company is getting over leveraged, the stock might deserve more of a discount, despite the rise in ROE . In case if the company is under-leveraged then it could be positive, and show that the company is managing itself better.

The DuPont Equation [Return on Investments (ROI)]

NI ROI Assets

The DuPont Equation [Return on Investment (ROI)]

NI Sales NI ROI X Sales Assets Assets ROI ( profitability) X (efficiency )
The firm's ROI is broken into two components: A profitability measure (net profit margin) An efficiency measure(total asset turnover)

Du Pont Analysis For HindalcoAn example

Du Pont Analysis NP Margin TATR Equity Multiplier ROE ROI 2011 9.04 0.51 1.55 7.20 4.64 2010 9.88 0.46 1.50 6.86 4.59 2009 12.24 0.50 1.52 9.39 6.17 2008 14.90 0.62 1.77 16.41 9.26

Beta ()
Beta measures the volatility of the systematic risk in a portfolio It measures how sensitive the price of a security is to the market movements, generally movements of the index. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. Beta is calculated using following formula;

How to interpret Betas ()

= 1: the stock has average market risk. The stock generally tends to go up (down) by the same percentage amount as the market. = 1.5: The stock generally tends to go up (down) by 50% (1.5x) more than the market. = 0.5: The stock generally tends to go up (down) by half as much as the market. = 0: the stock has no correlation with movements in the overall stock market. All of this firms risk would actually be firm-specific risk. < 0: The stock generally tends move in a direction opposite that of the market (very rare).

Firms that supply basic consumer goods (Proctor & Gamble) and utilities (phone, cable, gas, or electric) tend to have low Betas (lower than 1.0, often around 0.4 to 0.6). Firms that are in economically Mfg. industries would have higher Betas (greater then 1.0).

Capital Asset Pricing Model or CAPM

The CAPM (introduced in 1965) is used to estimate a stocks risk premium and required rate of return. We will use TCS stock as an example.

CAPM rTCS = rRF + TCS[rM - rRF]

rRF is the riskless rate, TCS is the Beta of TCS, rM is the required return on some well-diversified or market portfolio of assets (call it the market portfolio). The term [rM - rRF] is the market risk premium Tcs[rM - rRF] is TCSs risk premium

What is the market risk premium, given as [rM - rRF] in the CAPM?
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. Varies across time, but most estimates suggest it has ranged between 4% and 8% per year; 5 to 6% is considered a good estimate.

CAPM and required return for TCSs common stock

Let rRF=6%, rM=12%, and the Beta of TCS common stock is Tcs=0.19 rTcs = rRF + Tcs[rM - rRF] rTcs = 0.06 + 0.19[0.12 0.06] rTcs = 0.06 + 0.19[0.06] rTcs = 0.06 + 0.0114 =0.0714 or 7.14% Note the following items:
The market risk premium is [12% - 6%] = 6% TCSs risk premium is 0.19[12% 6%] = 1.14%.

Free Cash flow Calculations

Free Cash Flow is computed using the following formula: FCFF(Free Cash Flows to the Firm) = EBIT (1-Tax rate) + Noncash charges (such as D&A) - Capex Increase in Working capital FCFE (Free Cash Flows to the equity )= Net income or PAT + Noncash charges (such as D&A) - Capex - Increase in Working capital Or simply: FCFE = FCFF + Net borrowings - Net debt repayments