BEATING the inflation rate is needed in order to grow wealth over time.
Saving is important but is not enough. Insurance is also important but is not enough. Investing is needed. Investing in the Philippine stock market can be an attractive option for many Filipinos.
However, not all companies and stocks are the same. One way to differentiate the good from the bad would be through fundamental analysis. A popular tool that can be used to study the financial strength of listed companies is the DuPont analysis.
The DuPont analysis was developed by Donaldson Brown and was first used by the DuPont Co. in the 1920s. It focuses on the background leading to the return on equity measure, which is the ratio of net profit to stockholder equity. Return on equity is a key measure of profitability that shows how good a company is able to translate every peso of equity or net asset into profit.
There are three aspects that are considered in the DuPont analysis. These are: profitability; asset efficiency; and, financial leverage.
Profitability in the DuPont analysis is measured by the profit margin. The profit margin is the ratio of net profit to revenue. While growing revenue is imperative for any company, generating good profit levels should also be a priority.
One way that companies would be able to get a good profit margin is by being able to implement the right pricing for its products or services. The right price will be able to cover costs and consider anticipated impact on demand. The right price also helps build brand value of the company.
Another way to improve the profit margin is by being able to manage costs and expenses. Benjamin Franklin once said that we should be mindful of costs and expenses since a small hole can sink a great ship. Business is not just about growing revenue and pricing well. Cost of goods sold and operating expenses have to be tracked and managed.
A company must distinguish its muscle components from its fat components. A company must be able to negotiate well with its suppliers and work on efficiency.
Asset efficiency in the DuPont analysis is measured by asset turnover which is the ratio of net revenue to average total assets. This shows how good a company is able to convert every peso of its total assets into revenue.
For fixed assets, it should be able to generate financial projections on revenues to ensure that purchases would be worthwhile eventually. For working capital, it should be able to develop good programs related to management of current assets and current liabilities so its liquidity is favorable.
Financial leverage in the DuPont analysis is measured by the ratio of average total assets to average total stockholder equity. This shows how good a company is able to use its debt in order to grow assets.
Debt may have a common negative connotation. Within the context of a business, debt can actually help grow value if the use of debt would be toward effective and efficient initiatives. Getting a loan for business must therefore be strategic. Future benefits must outpace costs of debt so that risks taken will be justified.
There are two things that have to be taken into account when using the DuPont analysis.
First, the quality of the analysis will depend on the quality of the numbers. The good thing to note is that the financial statements of listed companies are audited by reputable audit firms. Second, the numbers and the ratios of a company must be benchmarked with the numbers and ratios of companies operating within the same economic sector. A good company must be performing better or at the same mark as the average levels.
Behind every number and ratio is a story. For investing in stocks, it would be good to do due diligence by studying developments that lead to financial performance. Informed decisions will potentially lead to the right investments. Every right investment helps take a person one step closer to financial freedom.
Gemmy Lontoc is a registered financial planner of RFP Philippines. To learn more about personal-financial planning, attend the 91st RFP program this August 2021. To inquire, e-mail [email protected] or text at 0917-6248110.