How does the modified DuPont decomposition of ROE work?

Question

AcadiFi · Accepted Answer

The modified (5-step) DuPont decomposes ROE into operating, financing, and tax components, giving much more diagnostic power than the classic 3-step.

ROE = (NI / EBT) × (EBT / EBIT) × (EBIT / Revenue) × (Revenue / Assets) × (Assets / Equity)

Components:

1. Tax burden (NI / EBT): how much of pre-tax income survives taxation.
2. Interest burden (EBT / EBIT): how much operating income survives interest expense.
3. EBIT margin: operating profitability.
4. Asset turnover: capital efficiency.
5. Financial leverage: balance sheet leverage.

Example: Copperfield Industrial reports NI = $84M, EBT = $108M, EBIT = $132M, Revenue = $1,450M, Assets = $1,800M, Equity = $600M.

- Tax burden: 84/108 = 0.778
- Interest burden: 108/132 = 0.818
- EBIT margin: 132/1450 = 9.1%
- Asset turnover: 1450/1800 = 0.806
- Leverage: 1800/600 = 3.0x

ROE = 0.778 × 0.818 × 0.091 × 0.806 × 3.0 = 14.0%

When ROE rises year over year, the 5-step reveals whether the driver is sustainable (operating margin, turnover) or fragile (leverage, lower tax rate). Rising leverage-driven ROE deserves skepticism because it amplifies downside as well.

How does the modified DuPont decomposition of ROE work?

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