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 Analog Devices
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.
Linear Technology offers very high returns on equity that are more than quadruple those of Texas Instruments, Analog Devices, and Cypress Semiconductor. Its net margins and leverage ratio are far higher than these peers. Linear also has the second highest asset turnover, behind Cypress. Analog Devices has the lowest ROE of these companies. While its net margins are second only to Linear Technology's, its asset turnover and leverage ratio bring down ROE.
Analog Devices creates circuits used in a wide range of industries, including aerospace, health care, and automotive. Its circuits are an important part of technology used to convert light, sound, and other inputs into electrical signals. Now that Texas Instruments has taken over National Semiconductor, Analog may feel pressure to make an acquisition of its own to ensure that it can maintain a competitive position. Fellow Fool Dan Caplinger points out a number of possible candidates, including Intersil, Linear Technology, and ON Semiconductor.
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 Texas Instruments. Motley Fool newsletter services have recommended buying shares of Linear Technology and Cypress Semiconductor. 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.