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 Annaly Capital Management
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| Annaly Capital Management | 8.2% | 79.7% | 0.01 | 8.03 |
|
Chimera Investment |
18.5% | 91.6% | 0.09 | 2.28 |
|
American Capital Agency |
28.4% | 92.1% | 0.03 | 10.46 |
|
Anworth Mortgage Asset |
12.7% | 88.2% | 0.02 | 6.95 |
Source: Capital IQ, a division of Standard & Poor's.
Each of these companies offers a truly amazing dividend, ranging from 12.7% for Anworth to 19% for American Capital Agency. And how do these guys do it? This DuPont formula screen shows clearly: high leverage and fat net margins. Net margins for these group ranges from 80% to 92%, while most are very highly leveraged, with the exception of Chimera. Those tasty dividends bring out the gambler in some investors, which may explain why you might want to avoid some of these too-tempting stocks.
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.
