Here's How The Home Depot 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 The Home Depot (NYSE: HD  ) creates its advantage.

Company

ROE

Net Margin

Asset Turnover

Leverage

The Home Depot, Inc.

15.3%

4.4%

1.55

2.24

Lowe's Companies Inc. (NYSE: LOW  )

9.7%

3.9%

1.40

1.79

Sears Holdings Corporation (Nasdaq: SHLD  )

2.5%

0.5%

1.72

2.81

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

When a company has an asset turnover ratio greater than 1.5 and a return on equity greater than 15%, it has a production advantage. Lowe's asset turnover ratio is lower than Home Depot's and Sears Holding's margins are much thinner. As a result, Home Depot is the only company in the table to generate an ROE higher than 15%.

Foolish bottom line
Using the DuPont formula, we can quickly see that The Home Depot 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 The Home Depot'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. Home Depot and Lowe's Companies are Motley Fool Inside Value recommendations. Motley Fool Options has recommended writing puts on Lowe's Companies. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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