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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 Priceline.com (Nasdaq: PCLN ) 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 margin shows 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
Source: S&P Capital IQ.
Priceline has by far the highest return on equity of the listed companies, with the highest asset turnover and the second-highest net margin. Ctrip.com (Nasdaq: CTRP ) has the second-highest ROE by focusing on high net margin, but it has the lowest asset turnover and leverage ratio. Expedia's (Nasdaq: EXPE ) margin comes in a distant third with a significantly lower asset turnover than sector leader Priceline. Orbitz (NYSE: OWW ) has returns on equity in the low negative numbers, which are caused by its negative net margin and exacerbated by its high leverage.
Priceline differentiates itself from industry peers like Expedia and Orbitz with its unique business model, in which the portal looks for a deal that matches a price named by the customer, rather than simply listing set prices offered by the listed companies. Recently, some have criticized the company for failing to keep up with competitors like Travelzoo in utilizing social media to attract customers. However, Priceline has done a good job with offering content that keeps its customers coming without the massive advertising campaigns using social media. It continues to grow at a brisk clip internationally.
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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