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What are the differences between three-step and five-step DuPont Analysis?

Modified on: 2018/07/16
A:

DuPont analysis is a method of mathematical decomposition that provides additional insight into elements that drive a company's return on equity, or ROE. DuPont analysis breaks ROE down into several contributing factors. Depending on the level of detail and specificity desired, a person can use three-step or five-step DuPont analysis.

Three-step DuPont analysis decomposes ROE, where the formula is net income / shareholders' equity, into three related components: the product of profit margin, asset turnover and financial leverage, or three steps. The formulas for those three ratios are as follows: net profit / net revenue, net revenue / total assets and total assets / shareholders' equity, respectively. In applying basic algebra, net revenue in the numerator of profit margin and the denominator of asset turnover cancel each other out. Similarly, total assets in the formulas for asset turnover and financial leverage cancel each other out. After applying that logic, all that remains is the numerator of profit margin, which is net income, and the denominator of financial leverage, which is shareholders' equity, or more simply, ROE.

The five-step method of DuPont analysis is an extension of the three-step method. It further breaks down ROE into two additional components, or steps, that provide more detail. Continuing from the three-step method, in step four, profit margin is broken into earnings before tax / sales multiplied by 1 minus the tax rate. From there, step five breaks out the effects of interest by taking earnings before interest and tax / sales and then subtracting the ratio of interest / sales from asset turnover. Much like the three-step method, using algebraic logic, the component parts cancel out, ultimately leaving the formula for ROE.

DuPont analysis is mainly used to understand cause and effect via examining driving forces underlying ROE. It is particularly useful when engaging in broader ratio analysis as a prospective investor or financial analyst. When comparing DuPont analysis between two competitors, the difference in uses for the three-step and five-step method is driven by whether there is a need for additional explanation beyond what is revealed using the three-step process.


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