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 Amgen
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
Amgen |
19.3% |
30.2% |
0.36 |
1.80 |
|
Biogen Idec |
18.5% |
23.2% |
0.56 |
1.42 |
|
Gilead Sciences |
54.2% |
38.5% |
0.78 |
1.80 |
|
Celgene |
20.0% |
27.9% |
0.57 |
1.26 |
Source: Capital IQ.
Each of these biotechs has a healthy ROE, with only Gilead standing far outside the others. Gilead has the highest net margins of this group, by a nice bit, and has the highest asset turnover and leverage ratios here. But the net margins at the other biotechs are something most companies would love to have -- 20%+ -- and that's really what sets biotechs apart from others, since leverage ratios and asset turnover are not particularly high.
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.
