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 Delta Air Lines (NYSE: DAL ) 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
|Delta Air Lines||NM||2.4%||0.81||(173.72)|
|United Continental Holdings||47.6%||2.3%||0.95||21.96|
|Alaska Air Group||21.5%||5.7%||0.85||4.48|
Source: S&P Capital IQ. NM = not measurable.
Here you have the airlines in a nutshell: low margins, low asset turnover, high leverage. United Continental Holdings' (NYSE: UAL ) has by far the highest returns on equity of the listed companies -- more than double that of Alaska Air Group (NYSE: ALK ) , which has the second highest ROE. This can be largely attributed to its huge leverage ratio, which is nearly five times higher than that of any other company. Alaska Air has the second highest ROE, with net margin more than double that of the other listed companies and the second highest leverage ratio.
Southwest Airlines (NYSE: LUV ) has returns on equity below 3%, which can largely be attributed to its very low net margins. Delta Air Lines' return on equity is not meaningful due to its negative leverage ratio (more liabilities than assets), but its asset turnover is the lowest of the listed companies and its net margins are comparable to United Continental Holdings'.
Delta, along with the rest of the airline industry, suffered a number of challenges during the recession. First, both individuals and businesses were cutting down on travel expenses to save money, which hurt Delta's revenues. Second, increases in fuel prices raised Delta's expenses, cutting further into its profit margins. Along with most other peers, the company faced this crisis by adding fuel surcharges and fees for baggage and food, which were previously complimentary. However, even with these moves, Delta needs to find ways to face the fundamental challenges facing airlines in order to find long-term success in the face of future rises in fuel charges and other challenges.
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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