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 ResMed
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
|Varian Medical Systems||28.5%||14.9%||1.05||1.79|
Source: S&P Capital IQ.
Varian Medical Systems
ResMed is one of the dominant providers of CPAP machines, which are used to treat sleep apnea, a medical condition in which a brief collapse in the airway causes individuals to momentarily stop breathing, which wakes them up. The growing problem of obesity, one of the leading causes of sleep apnea, has led to a growth in this market.
Accuray provides an innovation in radiological treatment products called CyberKnife, which helps patients avoid more invasive surgeries. However, Varian and Siemens both have products that compete with CyberKnife.
CONMED sells surgical equipment and devices useful in patient monitoring and minimally invasive surgeries. CONMED recently formed a distribution and marketing agreement with the Musculoskeletal Transplant Foundation (MTF). This agreement makes CONMED the exclusive worldwide marketing representative for MTF's sports medicine allograft tissues, and it allows the company to serve as the worldwide distributor for its platelet-rich plasma, which heals patients by using their own blood components. This agreement entitles the company to $63 million in upfront payments and has the possibility of bringing in $84 million over the next four years.
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. Motley Fool newsletter services have recommended buying shares of Intuitive Surgical. 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.