- The DuPont Framework is a tool
to decompose a company's return on equity
into three dimensions,
profitability, efficiency, and leverage.
Return on equity, or ROE, is a measure
of the amount of profit earned per dollar
of owner investment.
ROE is computed by dividing net income by equity.
In 2018, Walmart's ROE was 9%.
ROE for Target was 26%.
This means that shareholders who invested
$100 in Walmart earned profits of $9 in 2018.
If those shareholders had invested the same $100 in Target,
they would've earned $26.
ROE is the fundamental measure of financial performance
from the standpoint of the shareholders.
How much did we earn for each $100 that we invested?
So, at least in 2018, the Walmart shareholders
didn't do as well as did the shareholders of Target.
Why not?
Well, a quick way to get some insight into this question
is to use the DuPont Framework to decompose
the ROE for both Walmart and Target
to see where Walmart fell short.
Now, the DuPont Framework is named after the DuPont Company,
where this technique of analysis was invented.
The idea behind the DuPont Framework
is that return on equity,
computed as net income divided by equity,
can be mathematically decomposed into three ratios,
profit margin, asset turnover, and assets to equity.
The profit margin is the number of dollars in profit
for every $100 in sales.
This is a measure of a company's profitability.
Asset turnover is the number of dollars in sales
generated each year from each dollar of assets.
This is a measure of a company's efficiencies
in using its assets to generate sales.
Assets-to-equity is the number of dollars of assets
purchased for each dollar
of owner investment in the company.
The way to cause this ratio to be more than one
is to augment owner investment funds with borrowed money.
The assets-to-equity ratio
is a measure of financial leverage.
Let's use these 2018 numbers to compute
the DuPont Framework's ratios for Walmart and Target.
The DuPont Framework ratio calculations look like this.
Let's use these DuPont Framework numbers
to answer this question.
Why was Walmart's return on equity in 2018 only 9%,
when Target's was 26%?
We find the biggest reason for the difference
right there in the first DuPont Framework dimension,
profitability.
The profit margin, or return on sales numbers
show that in 2018, $100 in Walmart sales
resulted in net income of only $1.4,
whereas the same $100 in Target sales
resulted in net income of $3.9.
In 2018 Target controlled its expenses better
and so was able to squeeze more profit out of each sale.
Well, what about efficiency?
The asset turnover numbers show that
actually Walmart was more efficient than Target
at using its assets to generate sales in 2018.
$1 of Walmart assets generated $2.35 in sales,
whereas $1 of Target assets generated only $1.83 in sales.
This DuPont Framework analysis indicates
that the efficient use of assets
is one of Walmart's strengths.
Finally, let's look at the leverage measure,
assets-to-equity.
The leverage measure shows that Target
has been more aggressive at using borrowed money
to expand the size of its business.
For every $1 invested by shareholders
Target has be able to buy $3.65 in assets
by combining that $1 of shareholder investment
with $2.65 in borrowed money.
Walmart has not been as aggressive at using leverage.
More borrowed money means more assets
with the same initial shareholder investment.
More assets means more sales.
More sales means more profit,
all with the same initial shareholder investment.
Now, of course increased financial leverage
brings increased financial risk,
but we'll save that discussion for a different module.
Now the DuPont Framework analysis allows us to quickly see
why Walmart's 2018 return on equity
was so much lower than was Target's.
The primary reason, Walmart's 2018 profitability
was much lower than was Target's.
This low Walmart profitability
was partially offset by higher Walmart efficiency
in using assets to generate sales.
The DuPont Framework is a great tool
to illuminate how profitability, efficiency,
and leverage work together to determine
a company's return on equity.