How does the 5-factor DuPont decomposition work? I understand the 3-factor version but the extended one confuses me.

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AcadiFi · Accepted Answer

The 5-factor DuPont model peels the 3-factor version into finer layers so you can pinpoint *exactly* where a company's ROE is coming from. Here is how the components cascade: ```mermaid graph LR ROE[ROE] --> TB[Tax Burden
NI / EBT] ROE --> IB[Interest Burden
EBT / EBIT] ROE --> OM[EBIT Margin
EBIT / Revenue] ROE --> AT[Asset Turnover
Revenue / Assets] ROE --> EM[Equity Multiplier
Assets / Equity] style ROE fill:#c9a84c,color:#000 style TB fill:#1e3a5f,color:#fff style IB fill:#1e3a5f,color:#fff style OM fill:#1e3a5f,color:#fff style AT fill:#1e3a5f,color:#fff style EM fill:#1e3a5f,color:#fff ``` **The Formula:** ROE = (NI/EBT) x (EBT/EBIT) x (EBIT/Revenue) x (Revenue/Total Assets) x (Total Assets/Equity) Notice that if you multiply across, the intermediate terms cancel and you get NI/Equity = ROE. **Worked Example — Crestwood Manufacturing vs. Harborview Industries (FY 2025):** | Component | Crestwood | Harborview | |---|---|---| | Tax Burden (NI/EBT) | 0.75 | 0.78 | | Interest Burden (EBT/EBIT) | 0.82 | 0.95 | | EBIT Margin (EBIT/Rev) | 0.14 | 0.11 | | Asset Turnover (Rev/Assets) | 1.20 | 1.85 | | Equity Multiplier (Assets/Eq) | 2.50 | 1.60 | | **ROE** | **25.83%** | **23.19%** | **Crestwood:** ROE = 0.75 x 0.82 x 0.14 x 1.20 x 2.50 = 0.2583 = **25.83%** **Harborview:** ROE = 0.78 x 0.95 x 0.11 x 1.85 x 1.60 = 0.2319 = **23.19%** **Interpretation:** Crestwood has higher ROE but look *why*: - **Interest burden is lower (0.82 vs 0.95)** — Crestwood carries more debt, eating into EBIT. - **Equity multiplier is higher (2.50 vs 1.60)** — Crestwood is heavily leveraged. This *boosts* ROE arithmetically but introduces financial risk. - **EBIT margin is higher (14% vs 11%)** — Crestwood has better operating efficiency. - **Asset turnover is lower (1.20 vs 1.85)** — Harborview generates more revenue per dollar of assets. The takeaway: Crestwood's superior ROE is partly driven by leverage, not just operational excellence. In a downturn, that high equity multiplier becomes a risk factor. **What Each Factor Isolates:** 1. **Tax burden** — How much profit the government takes (lower = heavier tax) 2. **Interest burden** — How much debt service eats into operating profit 3. **EBIT margin** — Core operating profitability before financing 4. **Asset turnover** — Revenue efficiency of the asset base 5. **Equity multiplier** — Degree of financial leverage **Exam Tip:** If you see ROE increasing year-over-year, the exam loves to test whether the improvement came from operations (better margins, better turnover) or from financial engineering (higher leverage). Always decompose before concluding. Practice more DuPont problems in our CFA Level I question bank.

How does the 5-factor DuPont decomposition work? I understand the 3-factor version but the extended one confuses me.

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