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 DuPont
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.
DuPont's returns on equity are head and shoulders above the other listed companies', with a leverage ratio that is by far higher than the others, an asset turnover comparable to two out of the other three companies, and the second highest net margins. Albemarle isn't far behind, and while it has the lowest leverage ratio, it has a competitive asset turnover and much higher net margins than the others.
Dow Chemical comes in third, with a still reasonable ROE near 14% despite its net margins, which are much lower than its rivals'. Ashland's ROE, which is below 2%, isn't even in the competition.
While DuPont grew its revenues substantially in 2011, its five-year average annual revenue growth is below 5%, and its five-year average dividend growth rate is below 7%, which is disappointing for a company of DuPont's size. However, its current yield is a relatively attractive 3.6%, which shows well with Dow's 3.3% yield and is substantially higher than Ashland's 1.2% yield and Albemarle's 1.3% yield.
Some of DuPont's recent growth might be attributed to the continuing demand for chemicals despite the struggling economy, which has benefitted Olin, Celanese, and Eastman Chemical as well as the other companies in the table.
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. 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.