Using Industry-Adjusted DuPont Analysis to Predict Future Profitability

Abstract:     
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, L16

working papers series