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 priceline.com
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
priceline.com |
37.3% |
17.5% |
1.26 |
1.70 |
|
Orbitz Worldwide |
(30.9%) |
(8.5%) |
0.56 |
6.49 |
|
Expedia |
15.5% |
12.0% |
0.50 |
2.58 |
|
Ctrip.com International |
19.6% |
35.7% |
0.42 |
1.29 |
Source: Capital IQ, a division of Standard & Poor's.
The margin in this space can be enviable, leading to good returns on equity even though asset turnover tends to be low. Priceline doubles competitors' asset turnover, and its strong margin leads to the highest ROE here. Orbitz's high leverage cuts both ways, turning its negative margin into a very negative ROE. Expedia uses more leverage than priceline to help boost its lower margin, while Ctrip's outrageous margin is offset by lower leverage, but the Chinese trip site still manages a very good 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. 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 .
