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. But 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 Starbucks
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| Starbucks | 28.3% | 9.6% | 1.68 | 1.76 |
|
Panera Bread |
18.7% | 7.3% | 1.75 | 1.48 |
|
Wendy's/Arby's Group |
(0.2%) | (0.1%) | 0.70 | 2.16 |
|
Brinker International |
23.1% | 5.8% | 1.60 | 2.91 |
Source: Capital IQ, a division of Standard & Poor's.
Starbucks puts up a very attractive ROE, with a solid focus on each component of the DuPont formula. Brinker has similar asset turnover but uses more leverage to compensate for its smaller margin. Panera achieves a solid return on equity, but with lower margin and leverage than Starbucks. The negative ROE at Wendy's/Arby's is affected by negative margins, of course, but it really looks as if the company isn't using its assets efficiently enough, as evidenced in the much lower asset turnover.
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. And if you'd like to, add these companies to your watchlist.
