DuPont analysis is a potentially helpful tool for analysis that investors can use to make more informed choices regarding their equity holdings. The primary advantage of DuPont analysis is the fuller picture of a company's overall financial health and performance that it provides, compared to more limited equity valuation tools. A main disadvantage of the DuPont model is that it relies heavily on accounting data from a company's financial statements, some of which can be manipulated by companies, so they may not be accurate.
DuPont analysis is an equity evaluation approach that uses financial and leverage ratios that expand the profitability ratio of return on equity (ROE) into a more detailed and comprehensive measure.
Strengths
In addition to indicating the return on investment (ROI) for shareholders, DuPont analysis also factors in three important performance elements: profitability measured by profit margin, operational efficiency measured by asset utilization (specifically asset turnover), and financial leverage measured by the assets/equity multiplier. If ROE is higher due to improved operational efficiency or utilization of assets, this is commonly interpreted favorably by analysts. However, if the ROE for investors only improves due to a company using increased financial leverage, then the increased equity returns are not actually a result of increased profits, and the company may be overextending itself financially, making it a riskier investment.
The DuPont analysis model provides a more accurate assessment of the significance of changes in a company's ROE by focusing on the various means that a company has to increase the ROE figures. The means include the profit margin, asset utilization, and financial leverage (also known as financial gearing). A company can improve any or all of these elements to increase value and returns to shareholders through its management of costs, choices of financing, and usage of assets. DuPont analysis helps investors pinpoint the source of increased or decreased equity returns.
Drawbacks
While the DuPont analysis model can be a very helpful tool for investors, it is not without its weaknesses. The expansive nature of the DuPont analysis means that it requires several inputs. As with any calculation, the results are only as good as the accuracy of the inputs. DuPont analysis utilizes data from a company's income statement and balance sheet, some of which may not be entirely accurate. Even if the data used for calculations are reliable, there are still additional potential problems, such as the difficulty of determining the relative values of ratios as good or bad compared to industry norms. Financial ratios are always best evaluated on a comparison basis, showing how well a company is performing compared to its closest business peers or how well the company is doing in comparison with its own historical performance.
Seasonal factors, depending on the industry, can also be an important consideration, since these factors can distort ratios. Some companies always carry a higher level of inventory at certain times of the year, for example. Different accounting practices between companies can also make accurate comparisons difficult.
