Using Industry-Adjusted DuPont Analysis to Predict Future Profitability
Mark T. Soliman
University of Southern California - Marshall School of Business
Industry peer groups serve as both a theoretical and an intuitive benchmark in financial statement analysis. However, the practice of industry-adjusting financial ratios is sparse in existing financial statement analysis research. Much of the academic research on the mean reversion of profitability assumes economy-wide reversion targets. Economic theory supports the use of this target and empirical evidence is consistent with these predictions. However, some components of profitability may not revert to economy-wide averages because of structural differences across industries. For these components, industry averages serve as better long-term targets. DuPont analysis decomposes return-on-net-operating assets (RNOA) into two multiplicative components: profit margin and asset turnover, both of which are largely driven by industry membership. This paper investigates whether using industry-adjusted DuPont analysis is a useful tool in predicting future changes in RNOA. In contrast to prior research that used economy-wide targets and finds that these components are not useful in forecasting, I find that these components are informative when industry-adjusted and that using them helps predict future changes in RNOA in both in-sample and out-of-sample forecasting tests.
Number of Pages in PDF File: 48
Keywords: Industry Adjustment, Financial Statement Analysis, DuPont Analysis
JEL Classification: M41, L16working papers series
Date posted: October 26, 2003
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