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 Procter & Gamble
|
Company |
Return on Equity (ROE) |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
Procter & Gamble |
17.0% |
15.8% |
0.58 |
2.10 |
|
Colgate-Palmolive |
78.6% |
14.1% |
1.40 |
3.99 |
|
Clorox |
519.8% |
12.0% |
1.17 |
40.48 |
|
Prestige Brands |
10.7% |
11.4% |
0.38 |
2.39 |
Source: Capital IQ.
Clorox's gaudy return on equity is certainly eye-catching, but its secret is pretty obvious: The company runs on a sliver of equity. Its margins are in the middle of the range and its asset turnover is not the highest. Colgate's ROE is comprised of relatively high measures (at least among this bunch): good margins, high asset turnover, and a high leverage ratio. Meanwhile, P&G relies more heavily on high-margin products to boost ROE, since it turns assets into sales much slower and runs its business with less leverage. Prestige Brands boosts its ROE with leverage, since its asset turnover is particularly low.
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.
