As investors, we need to understand how our companies truly make their money. And there's a neat trick developed for just that purpose. It's called the Dupont formula.
By using the Dupont formula, you can get 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 Dupont formula breaks down return on equity into three components.
Return on equity = net margins X asset turnover X leverage ratio
High net margins show that a company is able to get customers to pay more for its products. Think luxury goods companies. High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Think service industries, which often do not have high capital investments. Finally, the leverage ratio shows how much the company is relying on debt to create profit.
Generally, the higher these numbers, the better. Of course, too much debt can sink a company, so beware of companies with very high leverage ratios.
Let's take a look at AT&T
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
AT&T |
19.8% |
17.6% |
0.46 |
2.52 |
|
Vodafone |
12.8% |
25.1% |
0.29 |
1.76 |
|
Verizon |
1.1% |
0.4% |
0.48 |
5.51 |
|
America Movil |
31.9% |
17.8% |
0.63 |
2.83 |
Source: Capital IQ, a division of Standard & Poor's.
AT&T has a strong return on equity, with net margins that are comparable to those of America Movil. However, the latter uses more leverage and greater asset turnover to boost its return on equity. With its business model, Vodafone has the fattest margins of the lot, but substantially lower leverage and asset turnover bring its return on equity down. Verizon has seen its return on equity trending lower in recent years. Its leverage and asset turnover are comparable with peers', but it seems to be losing out on margins. The situation should improve in the coming year, as Verizon's trailing margins are dragged down in part because of massive writedowns.
Breaking down a company's return on equity can often give you some insight into how it's competing against peers and what type of strategy it's using to juice its return on equity.
