As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont Formula -- can help us do so.
The DuPont Formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:
Return on equity = net margin x asset turnover x leverage ratio
What makes each of these components important?
- High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
- High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
- Finally, the leverage ratio shows how much the company is relying on liabilities to create its profits.
Generally, the higher these numbers, the better. That said, too much debt can sink a company, so beware of companies with very high leverage ratios.
Let's see what the DuPont Formula can tell us about The Andersons
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| The Andersons | 18.6% | 2.1% | 3.11 | 2.79 |
|
Archer Daniels Midland |
12.1% | 2.5% | 2.58 | 1.87 |
|
Cal-Maine Foods |
14.6% | 6.5% | 1.48 | 1.60 |
|
Bunge |
8.4% | 2.1% | 2.10 | 1.91 |
Source: Capital IQ, a division of Standard & Poor's.
The Andersons leads this group in return on equity, even though it doesn’t have the largest net margin. In fact, the margins at these companies are pretty skimpy. Instead, the Andersons uses high asset turnover and decent level of leverage to drive ROE. Archer Daniels Midland and Bunge look much the same, although lower asset turnover and leverage lead to a smaller ROE. Cal-Maine achieves a comparable ROE but by focusing on high margin.
Using the DuPont formula can often give you some insight into how a company is competing against peers and what type of strategy it's using to juice return on equity. To find more successful investments, dig deeper than the earnings headlines. If you'd like to add these companies to your watchlist, click on any of the links below:
- Add The Andersons to My Watchlist.
- Add Cal-Maine Foods to My Watchlist.
- Add Bunge to My Watchlist.
- Add Archer Daniels Midland to My Watchlist.
