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 Staples
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
| Staples | 13.8% | 3.8% | 1.85 | 1.98 |
|
Office Depot |
(7.9%) | (0.7%) | 2.61 | 3.95 |
|
OfficeMax |
7.2% | 0.6% | 1.77 | 6.2 |
|
Wal-Mart |
23.2% | 3.9% | 2.33 | 2.64 |
Source: S&P Capital IQ.
Staples notches a solid return on equity for a retailer, with a net margin that rivals the big dog in retailing, Wal-Mart. Still, its asset turnover sits near the lower end of these peers, and leverage is much lower than its peers', both of which hurt ROE. Wal-Mart puts up a strong ROE, using high asset turnover and leverage and a strong margin (for retail). The remaining two companies have much higher leverage, but that still doesn't make their return on equity attractive.
Using the DuPont formula can often give you some insight into how a company is competing against its 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 add any of these companies to your watchlist:
- Add Wal-Mart Stores to My Watchlist.
- Add Staples to My Watchlist.
- Add OfficeMax to My Watchlist.
- Add Office Depot to My Watchlist.
