Dupont Analysis and Strategy - PowerPoint Presentation

Slide1

Dupont Analysis and Strategy

P.V. Viswanath

Financial Theory

and

Strategic Decision-MakingSlide2

Standard Dupont Analysis

ROA = NI/TA= (NI/Sales) x (Sales/TA) = (Net Profit Margin) x (Asset Turnover)ROE = NI/TE = ROA x (TA/TE)= (NI/Sales) x (Sales/TA) x (TA/TE)= Net Profit Margin x Asset Turnover x Equity MultiplierBlunt instrument to monitor strategy because The denominator in the ROA includes assets claimed by all providers of capital, while the numerator includes only return to providers of equity.Assets include operating assets and financial assetsNet income includes income from operating activities, as well as interest income and expense, which are the consequence of financial decisions.Slide3

Alternative Decomposition

The key is to divide assets into operating assets and non-operating assets, and similarly the liabilities into those associated with the firm’s operations and those that are not.Some of the firm’s long-term liabilities are non-interest bearing, such as pension obligations, which are really part of the firm’s operations rather than its financing.We net the firm’s long-term assets net of these non-interest bearing liabilities to get Net long-term assets.Similarly, we would like to create a category of short-term assets that includes all short operating assets, net of all short-term operating liabilities. This gives us Operating Working Capital, defined as (Current Assets – Cash and Marketable Securities) – (Current Liabilities – Short term debt and current portion of long-term debt).Net Assets = Net long-term assets + Operating Working CapitalNet Debt = Total interest bearing liabilities – Cash and Marketable Securities(Cash is treated as negative debt, which is debatable.)Slide4

Alternative Decomposition

Similarly, we isolate and use net operating profit, rather than using Net Income (which includes interest).This is done by adding back interest expense to net income, after adjusting for their tax impact. Similarly, interest income.Thus, we first define (NIntAT) Net Interest expense after tax as (Interest expense – Interest Income)x(1-Tax rate).Then Net Operating Profit After Taxes (NOPAT) = Net Income + Net Interest Expense after taxes; and Net Income = NOPAT – NIntAT.Slide5

Alternative Decomposition

ROE = (NOPAT/Equity) – (NIntAT /Equity)= (NOPAT/Net Assets) x (Net Assets/Equity) – (NIntAT)/Net Debt) x (Net debt/Equity).If we rewrite Net Assets as Net Debt + Equity, we get the following:ROE = (NOPAT/Net Assets) x (1+Net Debt/Equity) – NIntAT/Net Debt x (Net debt/Equity).Defining NOPAT/Net Assets as Operating ROA and combining terms with NIntAT/Net Debt (which is the effective interest rate after tax on debt), we get ROE = Op ROA + (Op ROA – Eff Int Rate after tax) x (Net Debt/Equity)=Op ROA + (Op ROA – Eff Int Rate after tax) x Net fin leverage= Op ROA + Spread x Net financial leverageSlide6

Alternative Decomposition

Since we are primarily interested in using the Dupont decomposition to help us in operating decisions, we can further decompose Operating ROA.Operating ROA = NOPAT/Sales x Sales/Net Assets orOperating ROA = NOPAT Margin x Operating Asset TurnoverSlide7

Dupont Analysis Applied

We now try to relate Dupont Analysis to more specific operating strategies of the firm. In this process, we will have to extend the Dupont decomposition even further.Slide8

Five Generic Competitive Strategies

Type of Competitive Advantage Being PursuedMarket TargetLowest CostDifferentiationBroad Cross-Section of buyer

Overall Low-Cost

Provider Strategy

Broad

Differentiation Strategy

Best-Cost

Provider Strategy

Narrow

Buyer Segment

Focused Low-Cost

strategy

Focused Differentiation

StrategySlide9

How to Produce Cost Advantages

Perform value chain activities more cost-effectively than rivalsEconomies of scale; manifests itself in lower COGS/Assets ratio – (better asset utilization)Cost efficient supply-chain managementReduce inventory costs – (lower assets)Use online systems to achieve operating efficiencies (better COGS/Asset)Revamp the firm’s overall value chain to eliminate or bypass some cost-producing activities altogether (e.g. outsourcing)Slide10

Corporate Examples

WalMart: streamlining orders, automation of distribution centersNucor Corporation: Using relatively inexpensive electric arc furnaces where scrap steel and directly reduced iron ore are melted. Makes the use of coal, coke and iron ore unnecessary; cuts investment in facilities and equipment (eliminating coke ovens, blast furnaces, basic oxygen furnaces, and ingot casters).Southwest Airlines: no inflight meals, assigned seating; fast online reservation system; automated check-in equipmentQ: How do these activities affect the income statement and the balance sheet?Slide11

Differentiation Strategies

Incorporate Product attributes and user features that lower the buyer’s overall cost of using the product.Incorporate features that raise product performance.Incorporate features that enhance buyer satisfaction in noneconomic or intangible ways.Differentiate on the basis of competencies and competitive capabilities that rivals don’t have or can’t afford to matchSlide12

How to Differentiate

Product R&D activities – improved product design and performance features; e.g. Volvo or BMWSupply Chain activities that affect the performance or quality of the company’s end product. Starbucks has a better product because it has strict specifications on the coffee beans.Marketing, sales and customer service activities that result in superior technical assistance to buyers, faster maintenance and repair services, more and better product information for customers, more and better training materials for end users, better credit terms, quicker order processing etc.; e.g. MaytagSlide13

Low Cost Provider Strategy

Striving to achieve lower overall costs than rivals and appealing to a broad spectrum of customer, usually by underpricing rivals.Marketing Tactic: Low PriceOperating Tactic: Economies of ScaleSlide14

Broad Differentiation Strategy

Seeking to differentiate the company’s product offering from rivals’ in ways that will appeal to a broad spectrum of buyers.Marketing Tactic: General Advertising – need to reach a broad audience; this could be broken down by advertising channel. Higher expenditures on general TV ads, relatively fewer on direct marketing.Operating Tactic: Product R&DSlide15

Best-Cost Provider Strategy

Giving customers more value for the money by incorporating good-to-excellent product attributes at a lower cost than rivals. The objective is to have the lowest costs and prices compared to rivals offering products with comparable attributes.Marketing Tactic: Direct marketingOperating Tactic: R&D, efficient use of working capitalSlide16

Focused Low-Cost Strategy

Concentrating on a narrow buyer segment and outcompeting rivals by having lower costs than rivals and thus being able to serve niche members at a lower price.Marketing Tactic: Direct MarketingOperating Tactic: Efficient use of working capitalSlide17

Focused Differentiation Strategy

Concentrating on a narrow buyer segment and outcompeting rivals by offering niche members customized attributes that meet their tastes and requirements better than rivals’ products.Marketing Tactic: Direct MarketingOperating Tactic: R&DSlide18

Five Generic Competitive Strategies

Type of Competitive Advantage Being PursuedMarket TargetLowest CostDifferentiationBroad Cross-Section of buyer

Overall Low-Cost

Provider

Strategy

Low Price

Economies of Scale

Broad

Differentiation

Strategy

Gen

Advtg

Product R&D

Best-Cost

Provider

Strategy

Direct

Mktg

R&D, efficient use of

wkg

cap

Narrow

Buyer Segment

Focused Low-Cost

strategy

Direct

Mktg

Efficient use of working capital

Focused Differentiation

Strategy

Direct

Mktg

R&DSlide19

Five Generic Competitive Strategies

Type of Competitive Advantage Being PursuedMarket TargetLowest CostDifferentiationBroad Cross-Section of buyer

Overall Low-Cost

Provider

Strategy

Wal-Mart, 99 Cent Stores, Dollar Tree

Broad

Differentiation

Strategy

Starbuck’s, Land’s End, Victoria’s Secret

Best-Cost

Provider

Strategy

UPS, Budweiser

Narrow

Buyer Segment

Focused Low-Cost

strategy

Dairy Queen, Tabasco

Focused Differentiation

Strategy

Trader Joe’s, Micro-breweriesSlide20

Strategy

CostPriceQualityMarginVolume

Marketing

Tactic

Operating Tactic

Ratio

Low-cost provider strategy

Low

Low

Low

Low

High

Low

Price

Economies of Scale; high working capital utilization; high fixed asset utilization

Higher Sales/Net Working Capital; Higher

COGS/Assets

Broad differentiation strategy

Medium

High

High

High

High

Branding; General Advertising; moderately

high

mktg

costs

R&D

Higher R&D/Sales; lower

Sales/AR; high advertising expenses/Sales

Best-cost provider strategy*

Low-to-Medium

Medium-to-high

Higher

Low-to-medium

Medium-to-high

Direct Marketing; low marketing costs

R&D, efficient use of working capitalFocused low costsstrategyLowLowLow to mediumLowMedium-to-HighDirect Marketinghigh working capital utilization; moderately high fixed asset utilization Moderate COGS/Assets, Sales/A/R may not be highbut Sales/Assets are still relatively highFocused differentiationstrategymediumMedium-to-highMedium Medium LowDirect marketingR&DHigh Direct Mktg/Sales ratio; high R&D/Sales

Five Generic

StrategiesSlide21

A further decomposition?

If we separate Net Income into Sales – COGS – Direct Marketing expenses – General Advertising Expenses – Other expenses, we can write ROA as:Sales/Assets x [1-DME/Sales-GAE/Sales-Other expenses/Sales] – COGS/Assets.The inverse of Sales/Assets can be written as (NWC + Net Long-term Assets)/Sales and NWC can be further broken down, if necessary.