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 Starbucks (Nasdaq: SBUX) and a few of its sector and industry peers.
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
Starbucks |
28.1% |
8.8% |
1.79 |
1.78 |
|
Wendy's/Arby's (NYSE: WEN) |
(0.4%) |
(0.2%) |
0.70 |
2.17 |
|
Panera Bread (Nasdaq: PNRA) |
18.9% |
7.1% |
1.83 |
1.45 |
|
Brinker International (NYSE: EAT) |
17.7% |
5.1% |
1.56 |
2.77 |
Source: Capital IQ.
Starbucks boosts its ROE with high net margins and good asset turnover, even without taking on a lot of leverage. Panera looks similar in this regard, but its slightly lower margins and leverage reduce its ROE by nine percentage points. Brinker juices its middling margins with quite a bit of leverage, and you can spot a couple of different issues at Wendy's/Arby's. While its leverage is comparable to peers', its asset turnover is much lower and its net margins are slightly negative, so the company should be working on increasing those.
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.
