Common Size Analysis
Suppose someone told you that a particular company had $1 billion in earnings one year.
Is that good or bad? The answer depends on many factors, including:
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How much revenue did the company book in order to achieve those earnings?
How much did competitors of a similar size earn?
How much did the company earn last year?
How can an investor fairly compare one company’s earnings to another, given that they
cannot be exactly alike in all other respects? How can the firm’s performance be
compared to its past performance to determine whether it is improving? Common size
analysis is one tool that allows investors to compare companies across time and with
other companies.
The following articles explain how to use common size analysis in practice:
1. Vertical Common Size Income Statements shows how to express the income
statement as a percentage of sales and use this data to analyze a company’s
performance over time.
2. Horizontal Common Size Income Statements demonstrates how to express the
financial statements in each year as a percentage of a given base year. This
permits an investor to see if certain expenses, assets or liabilities are growing
faster than others.
3. Common Size Balance Sheets can be used to compare companies even when they
use different currencies.
4. Using Common Size Statements to Forecast Earnings shows how to do just that.
DuPont analysis
DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont
Model or the DuPont method) is an expression which breaks ROE (Return On Equity)
into three parts. The name comes from the DuPont Corporation that started using this
formula in the 1920s.
Basic formula
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net
profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)
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Operating efficiency (measured by profit margin)
Asset use efficiency (measured by asset turnover)
Financial leverage (measured by equity multiplier)
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ROE analysis
The Du Pont identity breaks down Return on Equity (that is, the return to equity that
investors have contributed to the firm) into three distinct elements. This analysis enables
the analyst to understand the source of superior (or inferior) return by comparison with
companies in similar industries (or between industries).
The Du Pont identity, however, is less useful for some industries, such as investment
banking, that do not use certain concepts or for which the concepts are less meaningful.
Variations may be used in certain industries, as long as they also respect the underlying
structure of the Du Pont identity.
Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is
by definition true.
Examples
High turnover industries
Certain types of retail operations, particularly stores, may have very low profit margins
on sales, and relatively moderate leverage. In contrast, though, groceries may have very
high turnover, selling a significant multiple of their assets per year. The ROE of such
firms may be particularly dependent on performance of this metric, and hence asset
turnover may be studied extremely carefully for signs of under-, or, over-performance.
For example, same store sales of many retailers is considered important as an indication
that the firm is deriving greater profits from existing stores (rather than showing
improved performance by continually opening new stores).
High margin industries
Other industries, such as fashion, may derive a substantial portion of their competitive
advantage from selling at a higher margin, rather than higher sales. For high-end fashion
brands, increasing sales without sacrificing margin may be critical. The Du Pont identity
allows analysts to determine which of the elements is dominant in any change of ROE.
High leverage industries
Some sectors, such as the financial sector, rely on high leverage to generate acceptable
ROE. In contrast, however, many other industries would see high levels of leverage as
unacceptably risky. Du Pont analysis enables the third party (relying primarily on the
financial statements) to compare leverage with other financial elements that determine
ROE among similar companies.
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ROI and ROE ratio
The return on investment (ROI) ratio developed by Du Pont for its own use is now
used by many firms to evaluate how effectively assets are used. It measures the combined
effects of profit margins and asset turnover.
The return on equity (ROE) ratio is a measure of the rate of return to stockholders.
Decomposing the ROE into various factors influencing company performance is often
called the Du Pont system.
Where
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Net profit = net profit after taxes
Equity = shareholders' equity
EBIT = Earnings before interest and taxes
Sales = Net sales
This decomposition presents various ratios used in fundamental analysis.
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The company's tax burden is (Net profit ÷ Pretax profit). This is the proportion of
the company's profits retained after paying income taxes.
The company's interest burden is (Pretax profit ÷ EBIT). This will be 1.00 for a
firm with no debt or financial leverage.
The company's operating profit margin or return on sales (ROS) is (EBIT ÷
Sales). This is the operating profit per dollar of sales.
The company's asset turnover (ATO) is (Sales ÷ Assets).
The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's
debt to equity ratio + 1. This is a measure of financial leverage.
The company's return on assets (ROA) is (Return on sales x Asset turnover).
The company's compound leverage factor is (Interest burden x Leverage).
ROE can also be stated as:
ROE = Tax burden x Interest burden x Margin x Turnover x Leverage
ROE = Tax burden x ROA x Compound leverage factor
Profit margin is (Net profit ÷ Sales), so the ROE equation can be restated:
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