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.
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.
Let's see what the DuPont Formula can tell us about Akamai Technologies
Return on Equity
Internap Network Services
Level 3 Communications
Source: Capital IQ, a division of Standard & Poor's.
Akamai achieves a middling return on equity, despite a quite-high net margin. Akamai's leverage ratio is quite low, as is asset turnover, both of which hurt ROE. Internap and Limelight both show negative returns due to losses, but sport similar or higher asset turnover and leverage. So a turnaround in margins would quickly boost their ROE. Level 3's return on equity is not measurable due to negative equity. Even if the company had positive equity, its ROE would still be negative because of its loss in the past four quarters.
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 here.
Jim Royal, Ph.D., does not own shares in any company mentioned. Motley Fool newsletter services have recommended buying shares of Akamai Technologies. 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.
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