THE DU PONT FORMULA

The preceding discussion of sustainable growth introduced a formula that provided insight into earnings per share by disaggregating it into several simple financial ratios.

Asset turnover × Return on sales = Return on assets

Like most ratio analysis, the Du Pont Formula is valuable not only for the questions it answers but also for the new ones it raises. If a company raises its return on assets by finding ways to reduce working capital without im­pairing competitiveness (thereby improving asset turnover), then it is likely to be able to p erform at the higher level. On the other hand, cutting back on necessary capital expenditures will also have a positive effect—in the short run—on return on assets. Not only will the denominator decline in the asset turnover factor as a result of depreciation, but return on sales will rise as fu­ture depreciation charges are reduced by lower capital outlays in the current year. Underspending will eventually hurt competitiveness, and therefore the company’s long-run return on assets, so analysts must probe to determine the true nature of shifts in these ratios.

A Du Pont analysis of the food processing industry (Exhibit 14.7) con­firms the value of examining the components of return on equity.

EXHIBIT 14.7 Du Pont Analysis of Food Processing Industry’s 2000 Results*

*Calculations are subject to rounding error.

(2.06X vs. 1.28X). McCormick appears to be far more profitable than Her­shey Foods, based on the companies’ respective returns on equity of 38.27% and 28.47%. That advantage resulted entirely from more aggressive financial leverage (4.62X for McCormick vs. Hershey’s 2.93X, the second most con­servative ratio in the industry). Hershey’s return on sales and, consequently, its return on assets were substantially higher than McCormick’s correspon­ding figures. The analysis shows investors that to benefit from McCormick’s higher return on equity, they must assume more financial risk than they would expose themselves to by owning the stock of Hershey Foods.

Some of the companies in Exhibit 14.7 achieved returns on equity that seem absurdly high, with Sara Lee at 97.06% and Ralston Purina at 120.93%. In part, those results reflected the two companies’ employment of the highest financial leverage within the industry. In addition, the extremely high ROEs derived from the companies’ very low levels of book value. As producers of branded food products, Sara Lee and Ralston Purina derive their equity value primarily from the consumer acceptance of well-known brands, rather than the physical plants in which they produce their goods.

The Modified Du Pont Formula

Carrying the disaggregation technique a step further, the Modified Du Pont Formula analyzes the sources of return on shareholders’ investment:

Return on assets × Financial leverage = Return on equity

As noted, the stock market will ordinarily value earnings at lower mul­tiples than they would otherwise command if the earnings were subject to unusual risks. Financial risk, as signified by financial leverage, is one con­sideration that may penalize a company’s P/E ratio. Generally speaking, an analyst will respond more favorably to a firm that raises its return on equity by increasing its return on assets than one that does so by leveraging its eq­uity more aggressively. Besides introducing greater volatility into the rate of

return, adding debt to the balance sheet demonstrates no management skill in improving operations. Furthermore, a company that has already fully uti­lized its debt capacity has no additional potential for increasing its return on equity by the same means. A somewhat underborrowed company, on the other hand, has hidden profitability potential that may be exploited (with concomitant benefits to shareholders) at a later point. The Modified Du Pont Formula enables investors to judge the quality of a company’s return on equity in much the same way that other financial tests can be applied to the quality of earnings.