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 EarthLink
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| EarthLink |
9.5% |
10.0% |
0.54 |
1.74 |
|
United Online |
12.3% |
6.0% |
0.91 |
2.26 |
|
Time Warner Cable |
16.2% |
7.4% |
0.44 |
5.00 |
|
NTELOS Holdings |
25.0% |
7.6% |
0.53 |
5.92 |
Source: Capital IQ, a division of Standard & Poor's.
The returns here go from middling to pretty strong, but the highest returns need significant leverage. That's the case with Time Warner Cable and NTELOS, which run with very high operating leverage. United Online uses more asset turnover to boost ROE, while EarthLink earns a higher margin than these peers do, but lower leverage makes its ROE look less attractive.
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 .
