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. But 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 China Mobile
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| China Mobile |
22.1% |
24.7% |
0.61 |
1.49 |
|
Telefonica |
36.6% |
15.9% |
0.56 |
4.22 |
|
France Telecom |
12.5% |
10.7% |
0.48 |
3.03 |
|
Telkom Indonesia |
27.9% |
16.8% |
0.71 |
1.73 |
Source: Capital IQ, a division of Standard & Poor's.
Among these international telecom players, the largest changes in return on equity are driven by margins and leverage. Telefonica scores the highest ROE, not with the highest margin, but mainly through more leverage. China Mobile's huge margins are offset by its much more modest leverage, and it's a similar situation for Telkom Indonesia. France Telecom has the lowest margin of these peers, but higher leverage helps boost the overall return on equity.
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. And if you'd like to, add these companies to your watchlist .
