As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont Formula -- can help us do so.
The DuPont Formula can give you 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 formula breaks down return on equity into three components:
Return on equity = net margins x asset turnover x leverage ratio
What makes each of these components important?
- High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
- High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
- Finally, the leverage ratio shows how much the company is relying on debt to create its profits.
Generally, the higher these numbers, the better. That said, too much debt can sink a company, so beware of companies with very high leverage ratios.
Let's see what the DuPont Formula can tell us about United Parcel Service
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| United Parcel Service |
40.5% |
6.4% |
1.49 |
4.22 |
|
FedEx |
9.2% |
3.5% |
1.47 |
1.76 |
|
Union Pacific |
15.1% |
15.7% |
0.39 |
2.50 |
|
CH Robinson Worldwide |
32.5% |
4.1% |
4.68 |
1.67 |
Source: Capital IQ, a division of Standard & Poor's.
UPS and FedEx are well-known rivals, but their returns on equity differ sharply. UPS delivers four times the ROE by securing almost twice the net margin using more than twice as much leverage. The margins on Union Pacific are particularly attractive, driving a solid ROE, even though asset turnover is much lower than any of these other names. CH Robinson also has a gaudy ROE, due less to margins or leverage than a very high asset turnover. So you can see three different kinds of focus in this sector to drive high returns on equity.
Using the DuPont formula can often give you some insight into how a company is competing against peers and what type of strategy it's using to juice return on equity.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
