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 EMC
|
Company |
Return on Equity |
Net Margins |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| EMC | 11.5% | 11.2% | 0.59 | 1.75 |
|
VMware |
10.9% | 12.5% | 0.48 | 1.81 |
|
NetApp |
21.1% | 12.4% | 0.71 | 2.41 |
|
Citrix Systems |
11.7% | 14.8% | 0.55 | 1.43 |
Source: Capital IQ, a division of Standard & Poor's.
The attractive net margins fall in a somewhat narrow range here, so asset turnover and leverage ratio will be key differentiators in how these companies produce return on equity. While NetApp's ROE is nearly double EMC's, that's due largely to somewhat higher asset turnover and a much higher leverage ratio. EMC's numbers look pretty similar to VMware's, of which EMC owns nearly 80%. Because of a lower leverage ratio, Citrix achieves an ROE in line with these peers, despite earning a significantly higher net margin.
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.
