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Earnings prediction with DuPont components and calibration by life cycle

blue sky and windmills

Financial accounting research aims to promote efficient capital allocation by advancing prediction models of future profitability. The prediction models can be advanced if they incorporate firm characteristics that are systematically associated with future profitability. A firm’s life-cycle stage appears to summarize many of these characteristics. Studies document that DuPont components, that is, profit margin and asset turnover ratio, enhance the prediction of future profitability. We examine whether DuPont components and a firm’s life-cycle stage add context to and improve the explanatory power of prediction models of profitability, and whether prediction improvements from these models inform investors.

We find that adding DuPont components as well as industry grouping improves prediction of future profitability over a basic estimation model. Using information about a firm’s life-cycle stage further improves prediction. For instance, introduction and growth firms exhibit momentum in profitability growth, especially if the profitability growth originates from improvements in asset turnover. We also find that prediction improvements by life-cycle calibration are concentrated among mature firms and firms that have high R&D intensity, low capital intensity, and low industry concentration. Finally, we show that investors and analysts initially rely more on the basic model prediction, relative to predictions made the expanded models that include DuPont components and life-cycle stages. This relative reliance on the basic model prediction declines over the year ahead when investors and analysts observe actual performance, which is more in line with predictions of the expanded models.

Our study contributes to the literature by illustrating the necessity of contextual financial analysis and the usefulness of the DuPont model and life-cycle calibration in forecasting profitability. Our findings suggest that users can add better context to financial information analysis by considering life-cycle stage of a firm. To learn more, see the full article:

Anderson, M., Hyun, S., Muslu, V. & Yu, D. (2023). Earnings prediction with DuPont components and calibration by life cycle. Review of Accounting Studies. DOI:10.1007/s11142-022-09748-3 (external link)