As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont formula -- can help us do so.
The DuPont formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:
Return on equity = net margin x asset turnover x leverage ratio
What makes each of these components important?
- High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
- High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
- Finally, the leverage ratio shows how much the company is relying on liabilities to create its profits.
Generally, the higher these numbers, the better. That said, too much debt can sink a company, so beware of companies with very high leverage ratios.
Let's see what the DuPont formula can tell us about Amgen
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
Amgen |
19.4% |
30.2% |
0.37 |
1.76 |
|
Biogen Idec |
15.3% |
21.3% |
0.57 |
1.42 |
|
Gilead Sciences |
39.3% |
34.6% |
0.66 |
1.73 |
|
Celgene |
16.9% |
24.3% |
0.47 |
1.50 |
Source: Capital IQ, a division of Standard & Poor's.
The net margins are all pretty strong here, with Amgen and Gilead astoundingly posting more than 30%, but Amgen's lower asset turnover pulls down its overall ROE. In contrast, Gilead uses high asset turnover to achieve double Amgen's ROE. With roughly similar margin, asset turnover, and leverage, the focus of Biogen and Celgene are comparable, and so are their solid returns 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. To find more successful investments, dig deeper than the earnings headlines. If you'd like to add these companies to your watchlist, or set up a new one, just click here .
