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 Delta Air Lines
Return on Equity
|Delta Air Lines||46.3%||1.3%||0.80||44.50|
United Continental Holdings
Source: S&P Capital IQ.
Things look really unattractive in the airline industry, with low margins dominating this industry. Delta's ROE is driven largely by its massive leverage, rather than by a healthy margin. And the same could be said for United Continental as well. Only Southwest presents something not approaching a nonsensical leverage ratio, and as one of the best operators, it achieves a meager ROE. AMR's negative equity makes the calculation of its ROE impossible.
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.
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Jim Royal, Ph.D., owns no shares in any company mentioned. Motley Fool newsletter services have recommended buying shares of Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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