How Do These Drug Companies Really Boost Their Returns?

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 Novartis (NYSE: NVS) and a few of its sector and industry peers.

Source: Capital IQ.

With attractive net margins of big pharmaceutical companies, each of these rivals earns a solid return on equity, and Novartis sits right in the middle of this pack. Its net margins are comparable to those of several peers, but its asset turnover is near the low end of this group. AstraZeneca provided an eye-popping ROE over the last 12 months, by focusing on high net margins and using more leverage. Teva and Sanofi had attractive net margins, but lower asset turnover (in Teva's case) and lower leverage (in Sanofi's case) dent return 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.