DuPont analysis, future firm performance, and stock returns : to what extent do the DuPont components have explanatory power regarding a firm's future profitability and its market value?
Creators: name: Andrina, Detzel
Publisher: name: ZHAW Zürcher Hochschule für Angewandte Wissenschaften
Year: 2023
Subjects: 332: Finanzwirtschaft

description: This master thesis aims to examine how financial information can be used to predict a firm’s future performance and value. Specifically, five hypotheses are tested to explore the usefulness of the DuPont analysis framework in predicting future profitability and stock returns. The thesis thus builds upon prior research by replicating previous findings with more recent data and analyzing the explanatory power of the leverage DuPont com-ponents, namely financial and operating liability leverage, in predicting a firm's future performance and value. While previous studies primarily focused on analyzing the predictive ability of the operational DuPont components, this thesis extends previous re-search by conducting a more comprehensive analysis that also incorporates a firm's financial activities. The study conducts pooled regression analyses based on a data sample comprised of 482 listed US companies to assess the predictive ability of all DuPont com-ponents. In addition, the thesis investigates whether market participants fully appreciate the components’ forecasting power.
The results indicate that the DuPont components possess explanatory power in predicting a firm’s future profitability and stock returns, thus providing valuable insights beyond what is already known from ΔROEt. Specifically, ΔATOt and ΔPMt are positively associated with a firm’s one-year-ahead profitability and market value, indicating that im-proved asset utilization efficiency and better cost control have a favorable impact. Market participants consider the information contained in both variables to be incrementally in-formative beyond ΔROEt. However, while the market fully appreciates the predictive power of ΔPMt, it fails to fully comprehend the implications of ΔATOt. The variable’s significant relation with future stock returns suggests that fully exploiting the information of ΔATOt can yield abnormal returns, indicating that the market is not completely efficient.
Moreover, the thesis’s findings highlight the importance of incorporating information about a firm’s leverage when forecasting and valuing its performance. The results demonstrate that a firm’s financial activities have significant predictive ability regarding its future performance. Specifically, ΔFLEVt is a positive and significant predictor regarding one-year-ahead return on equity, confirming the suggestion of the DuPont model that leverage can increase a firm’s return on equity. Despite its positive association with a firm’s future profitability, the regression results indicate that the market appears to negatively price higher financial leverage. Furthermore, the results show that considering operating liability leverage separately from financial leverage provides additional explanatory power in the forecasting and valuation context. In contrast to financial leverage, higher levels of operating liability leverage are favorably priced by market participants. These findings refute the capital irrelevance proposition of previous research and demonstrate that leverage affects a firm’s market value.