Quality Matters - Dupont Analysis.

 

Dupont Analysis.

 

There are lot of talks always circling about earnings in the market. This XYZ Company has reported earnings exceeding the consensus, share price up, share price down. But many a times investors forget that we live in a world where the quality of earnings is compromised. When we say many a times to our friends and family “I prefer quality over quantity”, we need to ask, do we apply that phrase in our investing as well? As an investor, I like to know from where my profits come from.

For those who don’t know what Dupont Analysis is, I would try to put it in as easy way as possible. Equity is the capital that a company has which is its own money and not borrowed, to conduct its operating activities. And Return on Equity or ROE is the measure of the return or profit that the company gets on this company’s own capital. ROE is further divided into 3 components Net Profit Margin, Asset Turnover and Financial Leverage.Net Profit Margin the margin of profit, company earns after subtracting all the operating and non-operating expenses and taxes which is simply the capacity of company to convert its revenues to profit. Asset Turnover is the efficiency or productivity of assets or how well can an asset of a company perform so as to increase its output. And the last one is Financial Leverage which is the indicator of how much of outside capital is used to amplify the earnings, which would have not been possible with the company’s own equity.

The formula goes like this:

ROE  = Net Profit Margin x Asset Turnover x Financial Leverage

          = (Capacity of maximum profit from Revenue) x (Maximum Efficiency of assets to increase profit)

x (Outside capital to amplify the profit).

Now that we have the basic picture, to make things little easier and to be able to understand the story behind the numbers. I substitute the words of NPM, Asset Turnover and Leverage with Pricing Power, Efficiency and Uncertainty. Of course these numbers mean more than the substituted words, but for now we will focus on these. Why, you ask? Here is the answer.

Net Profit Margin:

HUL	Mar/10	Mar/11	Mar/12	Mar/13	Mar/14	Mar/15	Mar/16	Mar/17	Mar/18	Mar/19
Net Profit Margin	11.81%	11.47%	11.91%	14.18%	13.50%	13.65%	12.88%	13.46%	14.67%	15.40%
Asset Turnover	192%	197%	209%	227%	215%	225%	221%	214%	202%	215%
Financial Leverage	98%	107%	108%	109%	109%	108%	107%	107%	109%	110%
ROE	87.76%	85.89%	88.19%	118.67%	125.19%	117.02%	79.13%	67.80%	74.85%	80.29%

(The Leverage numbers are adjusted to focus on long term debt by excluding short term debt to give a clear picture to give a clear picture of company’s health in long term. Short term debt is paid off generally within a year and also it is good for company like HUL to have high payables as they can temporarily use those funds for business. So, there are no red flags there. But just for the reference the unadjusted numbers of Hindustan Unilever ltd. are given in the end.)

In the above figure we can see, the NPM has a median of 13.57%. This margin is an indicator of the pricing power HUL has and thus making it one of the premium stocks. With this power HUL can pass the increased prices of raw material to the customers. HUL is into manufacturing of FMCG with products ranging from food and beverage to homecare products. There will always be increasing demand for these products. This is why Warren Buffet likes companies with pricing power. It’s a big deal to be able to price products without much influence of market factors to pull the pricing down.

Asset Turnover:

DMART	Mar/10	Mar/11	Mar/12	Mar/13	Mar/14	Mar/15	Mar/16	Mar/17	Mar/18	Mar/19
Net Profit Margin	0.70%	2.45%	2.69%	2.77%	3.41%	3.29%	3.67%	3.79%	5.23%	4.70%
Asset Turnover	161%	173%	186%	224%	262%	274%	281%	220%	269%	285%
Financial Leverage	162%	167%	174%	189%	188%	196%	203%	151%	121%	126%
ROE	2%	7%	9%	12%	17%	18%	21%	13%	17%	17%

Notice the NPM (3.35% median) is not as much as HUL, but Dmart still has an ROE with median of 17.5%. How is it possible? Because of the higher efficiency of Dmart. The low profit margins are compensated with higher efficiency (2.68) with in turn take the ROE higher. Dmart with its excellent quality of assets and excellent quality of management, combined, are able to produce 2.68 times an average asset could produce. Dmart is in Retail industry which doesn’t have a pricing power as such as the customers are always attracted to the stores which can give lowest possible prices for same quality of products. With this efficiency of assets, Dmart has gained a loyal customer base along with maintaining good profits with reduced pricing.

Financial Leverage:

Reliance Industries	Mar/10	Mar/11	Mar/12	Mar/13	Mar/14	Mar/15	Mar/16	Mar/17	Mar/18	Mar/19
Net Profit Margin	12%	7%	6%	5%	5%	6%	11%	10%	9%	7%
Asset Turnover	79%	86%	110%	110%	101%	74%	46%	43%	48%	57%
Financial Leverage	184%	200%	193%	199%	216%	231%	259%	268%	276%	258%
ROE	17%	13%	12%	11%	11%	11%	13%	11%	12%	10%

Now there comes Reliance Industries which notorious for leverage. As seen from the above figure, the ROE is majorly influenced by leverage (2.23 median). This means the debt on the company has been 2.23 times over a period of 10 years on average. The NPM is less (5.5% median, the Asset Turnover is less (8.7 median). Why does it matter   if RIL is getting 11% ROE on average over 10 years? 11% ROE is not that bad after all. That’s where the uncertainty part comes into the picture. In the end, leverage is outside money or borrowed money which has to be given back plus the interest. The main thought behind leverage is, what if in case in future, Reliance is not able to leverage itself or borrow capital due to the risk factor attached to it? The ROE will drastically fall down, which means the returns of the company will fall so will our returns as a shareholder. That’s why “Uncertainty” is the word I relate to when it comes to leverage.

Now if we compare these three companies, we will be comparing the relation between NPM, Asset Turnover and Leverage and thus their effect on the ROE or return. The best case scenario in a company will be high NPM, high Asset Turnover and low Leverage. The vice versa will be the worst case scenario. Although the best case scenario is far from real world as such companies are difficult to find and more difficult to be undervalued. But if we are dreaming, why not dream about the best.

We have just bifurcated the earnings for now, but in the end these are just numbers. We can’t buy food or cars with only numbers. We want the cash in multiples of those numbers. In next part we will see the how these numbers can be deceiving. Cash=Revenue? Relation of Cash and Earnings.

By Sarang Zagade (Student of the market, CFA Level 1 Exam Candidate).

DISCLAIMER:

•  These are writer’s personal opinions and can vary from the facts.
•  Writer in no way is promoting a stock for buying or selling as many other factors are not taken into consideration.
• Below are the unadjusted numbers of HUL.

RATIOS	Mar/10	Mar/11	Mar/12	Mar/13	Mar/14	Mar/15	Mar/16	Mar/17	Mar/18	Mar/19
Net Profit Margin	11.81%	11.47%	11.91%	14.18%	13.50%	13.65%	12.88%	13.46%	14.67%	15.40%
Asset Turnover	192%	197%	209%	227%	215%	225%	221%	214%	202%	215%
Financial Leverage	347%	371%	304%	415%	384%	353%	223%	230%	241%	232%
ROE	87.76%	85.89%	88.19%	118.67%	125.19%	117.02%	79.13%	67.80%	74.85%	80.29%