Here's How Oracle Creates Its Advantage

Famed value investor Chuck Akre has a simple formula for success. All you have to do is buy companies that can generate high returns on capital for a long, long time. As a result, he spends lots of time learning how a company generates a competitive advantage.

As an individual investor, you may not have as much time as Chuck and his analysts to research companies. Fortunately, the DuPont return on equity (ROE) formula can quickly identify whether a company has a consumer advantage or a production advantage. Here's how.

The DuPont ROE formula breaks down a company's return on equity into 3 parts:

  1. Net margin: net income/sales
  2. Asset turnover: sales/assets
  3. Leverage: assets/equity

Companies with high margins and low asset turnover have a consumer advantage. A consumer advantage can come from a company's brand, which allows a company to charge higher price, or a network effect, where a company can earn economies of scale.

Companies with low margins and high asset turnover have a production advantage. These companies use their assets to efficiently turn investments in capital assets into sales. At The Motley Fool, we prefer companies with low leverage. So we'll make sure that component isn't too high.

Using the model above, let's see how Oracle (Nasdaq: ORCL  ) creates its advantage.

Company

ROE

Net Margin

Asset Turnover

Leverage

Oracle Corp.

22%

22.9%

0.49

1.95

EMC Corporation (NYSE: EMC  )

9.8%

9.6%

0.59

1.73

VMware, Inc. (NYSE: VMW  )

8.8%

10.3%

0.48

1.76

Source: Capital IQ, a division of Standard & Poor's.

When a company generates a net margin greater than 15% and a return on equity greater than 15%, it has a consumer advantage. From the table above, Oracle clearly outshines the competition. Its profit margin is much higher than EMC Corp's and VMware's. As such, it earns significantly higher returns on equity.

Foolish bottom line
Using the DuPont formula, we can quickly see that Oracle has used its consumer advantage to generate attractive returns on equity. That's a helpful first step. But to make it into Chuck's portfolio, or ours, we need to see if Oracle's advantage is durable. I plan to use this sustainability framework and I recommend you do the same. A sustainable competitive advantage can help turn those high returns on equity into solid shareholder returns over time.

Million Dollar Portfolio associate advisor David Meier does not own shares of any of the companies mentioned. Vmware is a Motley Fool Rule Breakers pick. The Fool owns shares of Oracle. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1274371, ~/Articles/ArticleHandler.aspx, 12/22/2014 8:05:11 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement