The DuPont Equation (ROE)

In this video, we talk about the famous DuPont Equation. Watch now!

VIDEO SUMMARY

The DuPont Equation is one of the most important innovations in business. Before we get to the equation, I need to tall you the story of how the equation came about. Most of you know DuPont is a chemical company, and has been one of the biggest companies in the world for a long time. This equation was invented by somebody named Donaldson Brown. Donaldson is one of my personal heroes and he had an amazing career. Donaldson Brown did accounting and corporate finance at DuPont. He got an engineering degree in college and started working in the explosives department at DuPont in 1908. He was so successful, he became the manager of the whole department. He left this position to work in the Treasurer’s office managing the company’s money. It was his time in the treasurer’s office where he developed what is known as the DuPont equation. DuPont is the first place I can find in history records where they created a business laboratory. There was a secret room at DuPont called “the chart room.” The leadership of DuPont would come into this room, and Donaldson would show them financial charts, they would apply the DuPont equation, and they would make financial choices. Meanwhile, DuPont made a large investment in General Motors, and Donaldson become the VP of Finance at General Motors. Eventually he became vice chairman of the board of General Motors. This guy had an incredible career, starting out as an explosives engineer and ending up on the board of General Motors. You have to understand, during the time Donaldson worked in corporate finance at General Motors, it became the largest corporation in the world.

I am going to put up a photo of him. This is the DuPont Executive Committee in 1919. Donaldson Brown is the only person wearing a light suit. Now I do not know if he forgot it was picture day, or if we was just so radical that he wanted to stand out from everyone else. He certainly stands out in this picture.

The DuPont Company Executive Committee in April, 1919.  Donaldson Brown is standing in the light colored suit, second from right.

Website cited: https://web.archive.org/web/20151208153951/http://www.hagley.org/librarynews/research-donaldson-brown-father-roi

Now that we know the history, let us get into the equation. You have to realize what Donaldson was trying to do. Donaldson was sitting in the treasurer’s office doing corporate finance. The job of corporate finance is to look at the money you have and decide the best use for those funds. DuPont had all these different divisions. Donaldson was looking at all the money in the company treasury and trying to decide what was going to be the best return on investment. Back in the 1910s, the concept of return on investment was not well defined. The great innovation was Donaldson had the insight that you could define Return on Equity using three accounting ratios: Profit Margin, Asset Turnover, and Financial Leverage. I have talked about all three of these accounting ratios in other videos over the last couple of weeks, so I am not going to talk about them here in-depth. What is important to understand is the relationship between these ratios can help you understand Return on Equity.

Donaldson started with the accounting ratio Return on Equity. This is Net Income / Owner’s Equity. This ratio decribes that the owner’s put a certain amount of investment into a business which generates a certain amount of profit each year. This is useful information. However, it would be helpful to be able to drill down and understand what is driving Return on Equity. That is what the DuPont Equation achieves. The DuPont Equation says that Return on Equity = Profit Margin * Asset Turnover * Financial Leverage. This works because when you multiply these three ratios, sales and assets cancel each other out and you are left with Net Income over Owner’s Equity, or Return on Equity.

You will also notice that Profit Margin * Asset Turnover is the same as Return on Assets which is our good friend productivity. You can then shorten this equation to Return on Equity = Productivity * Financial Leverage. This tells you something very important. Obviously owner’s care about productivity, but they also care about something else. From an owner’s perspective, capital structure really matters. You want to know how much of the assets in a business comes from owner’s equity and how much comes from debt.

Let us go back to Donaldson. If you are going to take your money, and make an investment in a company, you are going to want to understand your Return on Investment, which will be Return on Equity. The DuPont equation tells us that Return on Equity for any organization is driven by only three things: Profit Margin, Asset Turnover, and Financial Leverage. Each company has three dials, which you can turn up or you can turn down. Any changes in these ratios will flow through to your Return on Equity. This is really powerful for company leaders, because you can control your organization with these three dials. You can take any one of these dials and crank it up, or crank it down. Let me give you some examples.

• Profit Margin is driven by sales. Can you more narrowly define your value proposition to meet market demand?
• Asset Turnover is driven by operations. Can you increase the efficiency of your operations?
• Financial Leverage is driven by your credit. Can you improve your credit rating?

I hope you can see that this equation is allowing you to understand what is driving your Return on Equity, and showing where you have opportunity to improve.

The big takeaway for me in this equation is the importance of Financial Leverage. Productivity, which is profit margin and asset turnover, is obviously important. But Financial Leverage allows you to take that productivity and ramp it up as your credit rating increases. For example, imagine you have two businesses with exactly the same productivity. One company has 100% Owner’s Equity, while the other company is 50% Owner’s Equity and 50% Debt. The company with debt, has DOUBLE the Return on Equity. They are taking that same amount of productivity and doubling it. However, in order to achieve this, the second company has to have a high enough credit rating to take out that much debt. Let us use another example. Imagine you have a restaurant with no debt that performs really well. Imagine you were to open a second restaurant on the other side of town. Also imagine that instead of using your own money to pay for that restaurant, you went out and funded it through debt. Now you have two restaurant locations. Assuming the productivity is the same at each location, you just doubled your Return on Equity without having to invest any more money.

The key to all of this is your credit rating. Typically when you open a new business, you do not have any credit history, so you will not be able to get very good debt. But if you have been in business for ten years, and have a proven track record of a strong balance sheet and consistent revenues each year, people will be willing to loan you money. You have to build your reputation that you have good credit. The way you do that is through good accounting. You need to:

• Make debt payments on time
• Pass your financial audits
• Have a robust accounting system
• Have a strong accounting team

If you accomplish these four things, it will allow you to access better capital markets. That is one of the reasons why accounting is so important. Accounting is a career where you can have a real impact on people’s lives. Think about this on a global scale. Humanity, as a whole, has a certain level of productivity, and a certain amount of capital to invest. If all of us as a society increased our credit rating, by making more fiscally responsible choices, we could ramp up Return on Equity for the entire planet. Accountants can do this, because you are taking the available investment dollars and stretching them so they go further. Donaldson did it for DuPont and General Motors, and now we can do it for the entire world.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.