Famed value investor Chuck Akre has a simple formula for success. All you have to do is buy companies that can generate high returns on capital for a long, long time. As a result, he spends lots of time learning how a company generates a competitive advantage.
As an individual investor, you may not have as much time as Chuck and his analysts to research companies. Fortunately, the DuPont return on equity formula can quickly identify whether a company has a consumer advantage or a production advantage. Here's how.
The DuPont ROE formula breaks down a company's return on equity into three parts:
- Net margin: net income/sales
- Asset turnover: sales/assets
- Leverage: assets/equity
Companies with high margins and low asset turnover have a consumer advantage. A consumer advantage can come from a company's brand, which allows a company to charge higher price, or a network effect, where a company can earn economies of scale.
Companies with low margins and high asset turnover have a production advantage. These companies use their assets to efficiently turn investments in capital assets into sales. At The Motley Fool, we prefer companies with low leverage. So we'll make sure that component isn't too high.
Using the model above, let's see how Amazon.com (Nasdaq: AMZN) creates its advantage.
|
Company |
ROE |
Net Margin |
Asset Turnover |
Leverage |
|---|---|---|---|---|
|
Amazon.com |
23.9% |
3.8% |
2.86 |
2.20 |
|
Barnes & Noble |
8.1% |
0.6% |
3.14 |
4.11 |
|
Borders Group |
(64.4%) |
(3.2%) |
1.88 |
10.65 |
Source: Capital IQ, a division of Standard & Poor's.
When a company has an asset turnover ratio greater than 1.5 and a return on equity greater than 15%, it has a production advantage. All of the companies in the table have an asset turnover ratio greater than 1.5, but only Amazon.com generates a return on equity higher than 15% because its low profit margins are still higher than Barnes & Noble and Borders Group.
Foolish bottom line
Using the DuPont formula, we can quickly see that Amazon.com has used its consumer advantage to generate attractive returns on equity. That's a helpful first step. But to make it into Chuck's portfolio, or ours, we need to see if Amazon.com's advantage is durable. I plan to use this sustainability framework, and I recommend you do the same. A sustainable competitive advantage can help turn those high returns on equity into solid shareholder returns over time.
