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 Nike
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
Nike |
21.2% |
10.3% |
1.43 |
1.45 |
|
lululemon athletica |
37.1% |
15.2% |
1.88 |
1.29 |
|
Under Armour |
14.5% |
6.2% |
1.70 |
1.38 |
|
Polo Ralph Lauren |
17.9% |
10.5% |
1.11 |
1.53 |
Source: Capital IQ, a division of Standard & Poor's.
Nike might be the big dog of apparel companies, but lululemon is certainly outclassing it here. Lululemon turns higher margins and better asset turnover into an ROE that is almost twice as great as Nike's, despite less leverage. Under Armour and Polo are no slouches either, with mid- to high-teens returns on equity. Under Armour's efficiently using its assets to generate sales, but its net margins really hurt its ROE. Polo achieves Nike-size margins, but lower asset turnover puts it behind the Swoosh. Interestingly, none of these companies is particularly egregious at using leverage to juice 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.
