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 Norfolk Southern
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
Kansas City Southern |
7.3% |
9.3% |
0.32 |
2.50 |
|
Norfolk Southern |
13.4% |
15.2% |
0.33 |
2.64 |
|
CSX |
16.7% |
14.3% |
0.38 |
3.12 |
|
Canadian National Railway |
18.8% |
27.1% |
0.31 |
2.23 |
Source: Capital IQ.
You can see right away that railroads rely on a fair bit of leverage to boost their returns on equity, and the industry as a whole is not particularly efficient at turning assets into sales, given the massive capital expenditures needed. Canadian National leads this group primarily due to its high net margins, since its asset turnover and leverage are the lowest here. CSX edges Norfolk Southern in ROE by focusing on asset turnover and using high leverage, despite having a lower net margin. Kansas City Southern achieves about half the return on equity of either of these players, largely due to inferior margins.
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.
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