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 Sherwin-Williams (NYS: SHW) and a few of its sector and industry peers:
Return on Equity
Valspar (NYS: VAL)
Masco (NYS: MAS)
Newell Rubbermaid (NYS: NWL)
Source: Capital IQ, a division of Standard & Poor's.
Sherwin-Williams posts a very strong return on equity, even without a particularly stellar net margin. The company's focus on asset turnover significantly boosts ROE. While Valspar has a similar net margin, its much lower asset turnover brings ROE to a solid 15.8%. While Masco has quick asset turnover and some leverage, its negative net margin pulls return on equity way negative. Newell Rubbermaid also notches a solid ROE, with numbers similar to Valspar's, but with more leverage.
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 watchlist, just click here.
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