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 PetMed Express
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
---|---|---|---|---|
PetMed Express |
21.5% |
9.0% |
2.20 |
1.09 |
VCA Antech |
11.3% |
7.6% |
0.81 |
1.76 |
MWI Veterinary Supply |
15.8% |
2.7% |
3.12 |
1.87 |
IDEXX Laboratories |
26.5% |
12.8% |
1.30 |
1.58 |
Source: Capital IQ, a division of Standard & Poor's.
There are some pretty decent returns in caring for Spot or Mittens, it seems. While none of these companies carries particularly high leverage, asset turnover and net margins are all over the map. IDEXX is able to pull out high margins from its business, while PetMed Express uses higher asset turnover to boost its ROE. MWI uses a very high asset turnover and more leverage than these rivals to offset lackluster margins. VCA Antech's much lower asset turnover pulls down its ROE, despite a respectable net margin and leverage in line with its peers.
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 .