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 Visa
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
|Discover Financial Services||30.3%||36.8%||0.09||8.81|
|Heartland Payment Systems||22.3%||2.2%||3.45||2.91|
Source: S&P's Capital IQ.
Visa's huge size gives it a competitive advantage. The company has more cards than MasterCard, Discover Financial, and American Express
Heartland's recent quarterly earnings trounced analysts' estimates, as the company ramped up processing volumes. Heartland grew revenue 13%, and more importantly projected 2012 earnings that handily beat what the experts were predicting: $1.54 per share to $1.32. In comparison, MasterCard grew last quarter's revenue at 20%, while Discover and Visa put up 23% and 13.8%, respectively.
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.
If you'd like to add these companies to your watchlist, or set up a new one, just click below:
Jim Royal, Ph.D., does not own shares in any company mentioned. The Motley Fool owns shares of Google, Heartland Payment Systems, and MasterCard. Motley Fool newsletter services have recommended buying shares of Heartland Payment Systems, Visa, and Google. Motley Fool newsletter services have recommended creating a written covered strangle position in American Express. 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.