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 Mohawk Industries
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
---|---|---|---|---|
Mohawk Industries |
5.9% |
3.5% |
0.84 |
1.91 |
Armstrong World Industries |
2.9% |
1.6% |
0.90 |
2.07 |
Knoll |
29.9% |
4.1% |
1.28 |
5.70 |
Herman Miller |
50.3% |
3.7% |
1.90 |
7.25 |
Source: Capital IQ, a division of Standard & Poor's.
The best returns on equity here are driven largely by high asset turnover and leverage. That's certainly the case for Knoll and Herman Miller, whose margins are about in line with Mohawk's. The major differentiator between the ROEs of Mohawk and Armstrong is largely net margin, with Mohawk doubling Armstrong's ROE using margins twice as great.
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 .