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 Best Buy
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| Best Buy | 24.4% | 2.8% | 2.33 | 3.77 |
|
Kohl's |
13.2% | 5.8% | 1.29 | 1.76 |
|
GameStop |
14.3% | 4.1% | 1.82 | 1.89 |
|
Gap |
25.5% | 8.2% | 1.80 | 1.73 |
Source: Capital IQ, a division of Standard & Poor's.
Best Buy and Gap both achieve very attractive returns on equity, but they go about that in different ways. In the ever deflationary world of electronics retailing, Best Buy settles for slim net margins and makes up for it with a higher asset turnover and leverage ratio. Gap, on the other hand, strives for meatier margins but runs at lower leverage more in line with retailing peers. Kohl's and GameStop put up respectable ROEs, with mid-range margins and typical leverage ratios.
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.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
