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?
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 Weyerhaeuser (NYS: WY) and a few of its sector and industry peers:
Return on Equity
Temple-Inland (NYS: TIN)
Plum Creek Timber (NYS: PCL)
International Paper (NYS: IP)
Source: Capital IQ, a division of Standard & Poor's.
Weyerhaeuser leads this pack by turning its high net margin and leverage into a very high ROE. Temple-Inland's much smaller margins are offset by quite high leverage, while International Paper uses higher asset turnover and sizeable leverage to boost its ROE. Plum Creek achieves a very attractive net margin, but its low asset turnover brings down ROE, despite leverage in line with peers'.
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.
At the time thisarticle was published Jim Royal, Ph.D.,owns shares in Plum Creek. The Fool owns shares of and has written puts on Plum Creek Timber. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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