How Does Big Pharma Really Make Its Money?

As investors, we need to understand how our companies truly make their money. Thankfully, there's a neat trick developed for just that purpose: the DuPont Formula.

The DuPont Formula can help you 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 that pioneered it, 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 lack high capital investments.) Finally, the leverage ratio shows how heavily the company relies on debt to create profit.

Generally, the higher these numbers, the better. But too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's take a look at Pfizer (NYSE: PFE) and a few of its sector and industry peers:

Source: Capital IQ, a division of Standard & Poor's.

Pfizer turns in the lowest ROE of this group, driven by the lowest margins, lowest asset turnover, and second-lowest leverage ratio. Merck coaxes the largest margins out of its products, but it could boost its ROE with more leverage (or less equity), since those metrics rank at the bottom of this list. Leverage is a key differentiator between Merck and Glaxo, which runs at double Merck's level, and has about twice the ROE. Meanwhile, Abbott runs in the middle of the pack in all measures.

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.