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 Exelon
Return on Equity
American Electric Power
|National Grid ( NYSE: NGG)||28.8%||15.4%||0.31||6.06|
Source: S&P Capital IQ.
Low double-digit margins, low asset turnover, and high leverage -- that sums up these utilities. National Grid edges out Exelon by securing a higher margin a good deal more leverage. Exelon, Duke, and American Electric all have comparable margins, so differences in their ROE are due largely to variations in asset turnover and leverage. Duke's lower leverage and asset turnover don't compensate for its somewhat higher margin, and its asset turnover sits at around two-thirds Exelon's.
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 shares of Exelon, National Grid, and Duke. Motley Fool newsletter services have recommended buying shares of Exelon and National Grid and creating a write covered strangle position in Exelon. 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.