Profitability Decomposition and Operating Risk

The DuPont decomposition of profitability into profit margin and asset turnover has been applied extensively to forecast future profits. This paper provides a complementary analysis under which the DuPont decomposition also informs about the risk that profits may differ from expectation. In the standard decomposition, the profit margin describes how sales translate into operating profit. Correspondingly, the analysis here shows how the profit margin informs about how variance in sales growth rates translates into variance in the growth rate of operating profit. We identify a measure that captures the effect. That measure also points to a role for the asset turnover. In the standard decomposition, the asset turnover describes how operating assets yield sales, while our analysis shows how the asset turnover combines with the profit margin to indicate the variability of operating profit resulting from those sales. The empirical results validate that the DuPont decomposition is useful for forecasting the variance in future growth rates in operating profits and also for forecasting the variance in future stock returns. Moreover, the decomposition also explains the implied volatility in option prices