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 Amgen
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
Source: S&P Capital IQ.
Gilead Sciences offers more than double the returns on equity of any of the other companies, and it does so through net margins, asset turnover, and a leverage ratio that are the highest in each category. Its net margins are particularly high compared with industry peers, outperforming the next closest company in the table by more than 9 percentage points in that category.
The rest of these companies also have fairly high returns on equity. Amgen and Novartis have comparable numbers in that category, with returns that are more than 6 percentage points below Biogen's. Amgen has the lowest asset turnover of the listed companies. Novartis' leverage ratio is comparable with those of the other companies, but its net margins are the lowest of the four companies.
Like other biotech companies, Amgen faces the constant challenge to keep its pipeline filled with drugs that will allow it to maintain and grow its revenue in the future. To this end, Amgen is seeking to gain FDA approval for the use of its Xgeva drug on patients who have not yet suffered bone metastases, with a decision due from the FDA by April 26. The ability to expand the use of Xgeva would improve Amgen's competitive advantage by allowing patients to take its drug before using Provenge or Taxotere, which belong to rival companies Dendreon and Sanofi, respectively.
Amgen recently began to offer a dividend and currently pays a 2.2% yield, which helps it stand out from Biogen and Gilead Sciences. However, Novartis offers a much higher yield at 3.5%. Other companies in the sector offer even more appealing dividends, with Eli Lilly a 4.9% yield, Pfizer a 3.7% yield, and Merck a 4.4% yield.
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. The Motley Fool owns shares of Dendreon. Motley Fool newsletter services have recommended buying shares of Novartis, Gilead Sciences, and Pfizer. 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.