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.
So in this series we let the DuPont do the work. Let's see what the formula can tell us about DISH Network
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.
So what does DuPont say about these four companies?
Return on Equity
Sirius XM Radio
Source: S&P Capital IQ.
DirecTV's and DISH Network's returns on equity are not measurable because they have negative equity, which is not necessarily a bad thing so long as the business is generating cash. The companies' net margins and asset turnover, on the other hand, are the highest of the listed industry peers. Sirius XM Radio has an extremely high ROE, achieved mostly through its very high leverage ratio and net margins comparable to DirecTV's and DISH Network's.
DISH Network's decision to buy Blockbuster's assets earlier this year has allowed it to set up the infrastructure it needs to offer digitally streaming movies, which some have claimed may allow it to compete with Netflix
However, the company is heavily in debt, which was increased by its $500 million settlement to pay TiVo
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 Netflix. 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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