Advanced Dupont: The 5-Step Model#

A company's ROE jumped from 12% to 18% this year. Great news, right? Not so fast. Using the 3-Step model, you might think the business improved. But the 5-Step model reveals the truth: operating margins actually declined while a one-time tax break and increased borrowing artificially inflated returns. The "improvement" is a mirage.

The 5-Step Advantage: While the 3-Step model tells you what drives ROE, the 5-Step model tells you why—separating genuine operational improvements from financial engineering and tax effects.

Why the 3-Step Model Falls Short#

The 3-Step model combines everything into "Net Profit Margin":

Net Margin = Net Income / Revenue

But Net Income is affected by:

Operating performance (core business)
Interest expenses (debt decisions)
Tax rates (often outside management control)

If net margin drops from 15% to 12%, the 3-Step model can't tell you whether:

The core business is struggling (bad)
Interest costs increased from new debt (concerning)
Tax rates went up (often temporary)

The 5-Step model separates these effects.

The 5-Step Dupont Formula#

ROE = Tax Burden × Interest Burden × Operating Margin × Asset Turnover × Financial Leverage

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

Let's understand each component:

Component 1: Tax Burden (Tax Retention Rate)#

Formula: Net Income / Pre-Tax Income (EBT)

What it measures: What percentage of pre-tax profits the company keeps after taxes.

Interpretation:

Value of 0.75 = Company keeps 75% of pre-tax profits (25% tax rate)
Value of 0.65 = Company keeps 65% of pre-tax profits (35% tax rate)
Higher is better (less tax paid)

Tax Burden	Effective Tax Rate	Interpretation
0.85+	<15%	Very low (tax havens, credits, losses)
0.75-0.85	15-25%	Low-moderate (efficient tax planning)
0.65-0.75	25-35%	Normal for most companies
<0.65	>35%	High (limited deductions, foreign taxes)

Real Example—Microsoft (2024):

Pre-Tax Income: $88.5 billion
Net Income: $72.4 billion
Tax Burden: $72.4B / $88.5B = 0.82 (18% effective tax rate)

Microsoft's global tax planning keeps their effective rate low. This is sustainable—they're not relying on one-time tax breaks.

Component 2: Interest Burden (Interest Retention Rate)#

Formula: Pre-Tax Income (EBT) / Operating Income (EBIT)

What it measures: What percentage of operating profits remains after paying interest on debt.

Interpretation:

Value of 1.0 = No debt interest (all operating profit flows through)
Value of 0.8 = 20% of operating profit goes to interest payments
Value of 0.5 = Half of operating profit consumed by interest (danger!)

Interest Burden	Interpretation	Concern Level
0.95-1.0	Minimal debt impact	🟢 Very safe
0.85-0.95	Low debt burden	🟢 Safe
0.70-0.85	Moderate debt burden	🟡 Monitor
0.50-0.70	High debt burden	🔴 Concerning
<0.50	Severe debt burden	🔴 Danger

Real Example—AT&T (2024):

Operating Income (EBIT): $24.5 billion
Interest Expense: $6.8 billion
Pre-Tax Income: $17.7 billion
Interest Burden: $17.7B / $24.5B = 0.72

AT&T pays nearly 28% of its operating profits to bondholders. This limits how much earnings can flow to shareholders and reduces financial flexibility.

Interest Burden Warning Signs

If Interest Burden falls below 0.70, the company is paying significant profits to creditors. If it falls below 0.50, the company may struggle to meet debt obligations during downturns. This is a bankruptcy warning signal.

Component 3: Operating Margin (EBIT Margin)#

Formula: EBIT / Revenue

What it measures: The pure profitability of core business operations, before considering how the business is financed or taxed.

This is the most important component. Operating margin reflects:

Pricing power
Cost efficiency
Competitive position
Core business health

Changes in operating margin indicate real business improvements or deterioration.

Operating Margin	Interpretation	Typical Industries
30%+	Exceptional	Software, luxury, pharma
20-30%	Strong	Tech hardware, branded goods
10-20%	Good	Manufacturing, services
5-10%	Average	Retail, food, industrials
<5%	Low	Grocery, discount retail, airlines

Real Example—Nvidia (2024):

Revenue: $60.9 billion
Operating Income: $32.9 billion
Operating Margin: $32.9B / $60.9B = 54%

Nvidia's operating margin is extraordinary—reflecting the AI chip boom and limited competition. This is the gold standard for operational excellence.

Components 4 & 5: Asset Turnover & Leverage#

These remain identical to the 3-Step model:

Asset Turnover = Revenue / Total Assets
Financial Leverage = Total Assets / Shareholders' Equity

Complete 5-Step Calculation: Microsoft#

Let's work through Microsoft's full 5-Step Dupont analysis:

Financial Data (FY 2024):

Line Item	Value
Revenue	$245.1B
Operating Income (EBIT)	$109.4B
Interest Expense	$1.9B
Pre-Tax Income (EBT)	$88.5B
Net Income	$72.4B
Total Assets	$512B
Shareholders' Equity	$268B

5-Step Calculation:

Component	Formula	Calculation	Value
Tax Burden	NI / EBT	$72.4B / $88.5B	0.82
Interest Burden	EBT / EBIT	$88.5B / $109.4B	0.81
Operating Margin	EBIT / Revenue	$109.4B / $245.1B	44.6%
Asset Turnover	Revenue / Assets	$245.1B / $512B	0.48x
Leverage	Assets / Equity	$512B / $268B	1.91x

ROE Calculation:

ROE = 0.82 × 0.81 × 0.446 × 0.48 × 1.91
ROE = 27.2%

Interpretation:

Tax Burden (0.82): Efficient tax management, keeps 82% of pre-tax profits
Interest Burden (0.81): Some debt impact, but manageable
Operating Margin (44.6%): Exceptional—cloud and software business very profitable
Asset Turnover (0.48x): Low, but normal for tech companies with large intangible assets
Leverage (1.91x): Conservative for a company of this size

Microsoft's ROE is driven by genuine operational excellence (44.6% operating margin), not financial engineering.

Case Study: Spotting Financial Engineering#

Company A: Genuine Improvement#

Metric	Year 1	Year 2	Change
Tax Burden	0.75	0.75	—
Interest Burden	0.90	0.90	—
Operating Margin	12%	16%	+4%
Asset Turnover	1.2x	1.2x	—
Leverage	2.0x	2.0x	—
ROE	19.4%	25.9%	+6.5%

Analysis: ROE increased entirely due to operating margin improvement. The core business got better—this is sustainable, high-quality growth. Verdict: Buy signal.

Company B: Financial Engineering#

Metric	Year 1	Year 2	Change
Tax Burden	0.70	0.90	+0.20
Interest Burden	0.95	0.75	-0.20
Operating Margin	15%	12%	-3%
Asset Turnover	1.0x	1.0x	—
Leverage	2.0x	3.0x	+1.0x
ROE	20.0%	24.3%	+4.3%

Analysis:

ROE increased, which looks good on the surface
But operating margin decreased (core business weakened)
Tax burden improved dramatically (one-time tax benefit?)
Interest burden decreased (debt costs rising)
Leverage increased significantly (more borrowing)

This company is masking operational decline with tax tricks and debt. Verdict: Major red flag—avoid or sell.

The Financial Engineering Playbook

Companies can temporarily inflate ROE by:

Taking one-time tax benefits (tax burden jumps)
Borrowing more money (leverage increases)
Cutting R&D or maintenance (margins temporarily rise but future suffers)

The 5-Step model exposes these tactics by separating operational performance from financial manipulation.

Trend Analysis Framework#

Track each component over 5 years to understand the trajectory:

Healthy Company Pattern#

Component	Trend	Interpretation
Tax Burden	Stable (0.75-0.80)	Consistent tax planning
Interest Burden	Stable or rising	Managing debt responsibly
Operating Margin	Stable or rising	Core business strong
Asset Turnover	Stable	Consistent efficiency
Leverage	Stable or declining	Not relying on debt

Warning Sign Pattern#

Component	Trend	Concern
Tax Burden	Spiking upward	Likely one-time benefits
Interest Burden	Declining	Debt burden growing
Operating Margin	Declining	Core business weakening
Asset Turnover	Declining	Assets not productive
Leverage	Increasing	Borrowing to mask problems

Industry-Specific Considerations#

Different industries have different "normal" ranges:

Technology Companies#

Component	Typical Range	Notes
Tax Burden	0.80-0.85	Aggressive tax planning common
Interest Burden	0.90-1.0	Usually minimal debt
Operating Margin	20-40%	High if scaled, low if investing
Asset Turnover	0.4-0.8x	Intangibles drag this down
Leverage	1.2-2.0x	Generally conservative

Banks#

Component	Typical Range	Notes
Tax Burden	0.75-0.80	Normal corporate rates
Interest Burden	N/A	Interest is their business
Net Interest Margin	2-4%	Replaces operating margin
Asset Turnover	0.03-0.06x	Very low by design
Leverage	8-12x	High but regulated

Retailers#

Component	Typical Range	Notes
Tax Burden	0.70-0.75	Standard rates
Interest Burden	0.80-0.95	Varies by debt level
Operating Margin	3-8%	Thin margins normal
Asset Turnover	2.0-3.5x	High is critical
Leverage	2.0-4.0x	Moderate to high

Using 5-Step Dupont for Investment Decisions#

The Decision Matrix#

Operating Margin Trend	Leverage Trend	Action
Improving	Stable or decreasing	Strong Buy
Stable	Stable	Hold
Stable	Increasing	Caution—investigate
Declining	Stable	Concern—monitor closely
Declining	Increasing	Sell

Key Questions to Ask#

Is operating margin sustainable?
- Compare to competitors
- Check for one-time items in EBIT
- Review R&D and marketing spending trends
Is the tax burden realistic?
- Compare to statutory rate
- Check for loss carryforwards or credits
- Will it normalize in future years?
Is the interest burden stable?
- Check debt maturity schedule
- Will rates reset higher?
- Interest coverage ratio above 4x?
Is leverage appropriate for the industry?
- Compare to peers
- Check debt covenants
- Assess ability to pay down debt

Common Analytical Mistakes#

Mistake	Problem	Solution
Ignoring interest income	Banks earn interest, not just pay it	Use net interest for financial firms
Using one year's data	Tax benefits and one-time items distort	Use 3-year averages
Not adjusting for non-recurring items	Special charges affect EBIT	Normalize for one-time costs
Comparing across industries	Banks vs. tech is meaningless	Only compare within sectors
Ignoring operating leases	Some debt is off-balance sheet	Capitalize leases in leverage

The Professional Analyst's Approach

Wall Street analysts typically:

Calculate 5-Step Dupont for the past 5 years
Forecast each component separately
Build the ROE forecast from the components
Flag any component trending unfavorably
Weight operating margin trends most heavily

This approach catches deteriorating businesses before headline ROE reflects the problems.

Key Takeaways

The 5-Step formula: ROE = Tax Burden × Interest Burden × Operating Margin × Asset Turnover × Leverage
Tax Burden (NI/EBT): Shows how much profit survives taxation. Values above 0.80 indicate efficient tax management.
Interest Burden (EBT/EBIT): Reveals debt's bite. Below 0.70 is concerning; below 0.50 is dangerous.
Operating Margin (EBIT/Revenue): The most important component—shows core business health independent of financing decisions.
Red flag pattern: Rising ROE + declining operating margin + increasing leverage = financial engineering, not real improvement.
Quality pattern: Rising ROE + rising operating margin + stable/declining leverage = genuine business improvement.
Microsoft example: 27% ROE driven by 45% operating margin—high quality. AT&T example: 28% of operating profits go to interest—concerning debt burden.
Always track 5-year trends, not just single-year snapshots.
Different industries have different normal ranges—compare within sectors only.