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 Akamai
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
Internap Network Services
Level 3 Communications
Source: S&P Capital IQ.
*Because Level 3 has negative average equity, its return on equity is not measurable.
Akamai Technologies offers a return on equity far above that of the other companies and is the only one offering positive net margins. Its asset turnover and leverage ratio, however, are comparable with some peers. Internap's net margins are slightly negative, but it has the highest asset turnover and leverage ratio of these companies, though that still gives it a negative return on equity.
Limelight has returns on equity in the low negative numbers, caused by its very low net margins. Level 3 has the lowest numbers in each category. While its ROE is not measurable, we have the information to determine that the company is in poor shape according to the DuPont Formula rubric.
Akamai grew more slowly in 2011 than in 2010. One major setback in 2010 occurred when Netflix dropped Akamai as its sole provider for streaming video and added Limelight Networks and Level 3 to its providers. While the growing amount of content on the Internet has the potential to increase the demand for the company's data-delivery technology, Akamai faces competition from other companies, including EdgeCast and Cotendo, which have landed major clients in AT&T and Google.
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 in AT&T. The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Netflix and Google. 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.