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 Bridgepoint Education
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
|ITT Educational Services||207.3%||20.5%||2.14||4.73|
Source: S&P Capital IQ
These businesses flourished during the first part of the economic recession, as unemployed workers went back to school to increase their marketability and funded their education with student loans. In 2010, however, the industry came under pressure as the government realized that many for-profit educational institutions, including Corinthian Colleges, ITT Educational Services, and Strayer
Bridgepoint Education, however, has performed better than many of these companies, with higher repayment rates among its attendees. It has also seen increases in its enrollment, while its industry peers have seen declines. In addition, Bridgepoint has repurchased a substantial number of its shares.
Apollo offered a setback in April of last year, when Arizona Gov. Jan Brewer vetoed a bill that would have given it and other Arizona companies millions of dollars in tax breaks. It responded to this decision with threats to move the University of Phoenix from the state. However, since the state already plans to phase in tax cuts for businesses in 2014 and make other alterations that Apollo wants, it's unclear whether the company has sufficient reason or motivation to follow through on these threats.
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., does not own shares in any company mentioned. The Motley Fool owns shares of Bridgepoint Education. Motley Fool newsletter services have recommended creating a put write position in Bridgepoint Education. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.