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.
So in this series, we let the DuPont do the work. Let's see what the formula can tell us about Amazon.com (Nasdaq: AMZN ) and a few of its peers.
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.
So what does DuPont say about these four companies?
Return on Equity
|Overstock.com (Nasdaq: OSTK )
|eBay (Nasdaq: EBAY )
|Blue Nile (Nasdaq: NILE )
Source: S&P Capital IQ.
Amazon.com has the second highest returns on equity, with net margins, asset turnover, and leverage ratio falling in the middle of the pack. Blue Nile has the highest returns on equity, at a whopping 43.5%, with the second highest net margins, asset turnover, and leverage ratio. Overstock.com has returns on equity in the negative, because of negative net margins. eBay's ROE is comparable to Amazon's and is largely attributable to its very high net margins.
While Amazon was once a high-growth stock, it is now looking pretty pricey given its current slower growth and its lack of dividend. However, the company has a history of strong innovation, which may allow it to find new competitive advantages that promote more growth in the future.
For example, Amazon recently began offering free streaming video to its Amazon Prime members, which may help it create a competitive advantage against Netflix (Nasdaq: NFLX ) , especially now that customers are looking elsewhere after becoming irritated with recent price increases and other suggested changes at the company. Amazon is also well known for its Kindle and its new tablet, which is taking aim at Apple.
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.
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