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 liabilities 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 PotashCorp
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
PotashCorp |
22.9% |
29.3% |
0.40 |
1.94 |
|
Mosaic |
21.0% |
23.0% |
0.63 |
1.46 |
|
Agrium |
12.1% |
6.1% |
1.02 |
1.94 |
|
CF Industries |
7.3% |
6.2% |
0.59 |
1.99 |
Source: Capital IQ, a division of Standard & Poor's.
There's certainly some attractive ROEs in this group, bolstered by very strong net margins. PotashCorp has margins approaching 30%, but the lowest asset turnover of this group. Mosaic puts up a similar return on equity even with the lower margins and leverage, due to its much greater asset turnover. Agrium and CF Industries show similar net margins and leverage, so asset turnover is the key differentiating factor in their ROE.
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.
