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 Formula do the work. Let's see what the formula can tell us about Novartis (NYSE: NVS ) 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 the DuPont Formula say about these four companies?
Return on Equity
|Pfizer (NYSE: PFE )
|GlaxoSmithKline (Nasdaq: GSK )
|Merck (NYSE: MRK )
Source: S&P Capital IQ.
GlaxoSmithKline offers very high returns on equity that are more than 4 times higher than that of the other companies. Its net margins are the highest, and its leverage ratio dwarfs that of the other companies, so no surprise that it leads in ROE. Novartis has the second highest returns on equity, with the second highest net margins and the second highest leverage ratio. Merck has returns on equity not far behind Novartis'. While its net margins and leverage ratio are the lowest of these companies, it makes it up on asset turnover. Pfizer has the lowest returns on equity, hurt by its low leverage ratio.
Novartis gains some diversity in the pharmaceutical sector through its involvement in both the development of new drugs and the production and sale of generic drugs. The company recently developed a treatment for patients with obstructive pulmonary disease. Called Onbrez Breezhaler, the treatment gained European approval in mid-2010 and FDA approval in March of 2011. Novartis' involvement in generics brings in lower margins but offers a cushion against the potential downsides of its involvement in the riskier name-brand-drug market. Even the development of successful drugs has the downside of facing huge declines in sales once patents expire.
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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