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 PPL (NYS: PPL) and a few of its sector and industry peers:
Return on Equity
Calpine (NYS: CPN)
Dominion Resources (NYS: D)
Progress Energy (NYS: PGN)
Source: Capital IQ, a division of Standard & Poor's.
With this industry's high leverage and low asset turnover, the major differences in ROE should be determined by net margin. PPL leads this group in ROE and also has the highest margin. It's followed closely by Dominion, which has a similarly high margin. Progress Energy sports the lowest leverage of this group and its high single-digit margins turns into a similar ROE. Although Calpine has the highest asset turnover and leverage of this group, its negative margin drives ROE into the red.
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 We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.Jim Royal, Ph.D.,owns shares of Dominion.Motley Fool newsletter serviceshave recommended buying shares of Dominion Resources. 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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