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 Visa (NYS: V) and a few of its sector and industry peers:
Return on Equity
MasterCard (NYS: MA)
Discover Financial Services (NYS: DFS)
Heartland Payment Systems (NYS: HPY)
Source: Capital IQ, a division of Standard & Poor's.
Visa has a solid return on equity, but it's less than a third of what key rival MasterCard achieves. While Visa does earn a much higher net margin, the real difference in their performance is in asset turnover, and MasterCard's somewhat higher leverage also boosts that company's ROE. Discover achieves a strong ROE, with similar margins as Visa and MasterCard, but its use of leverage really drives return on equity. Heartland also records a solid ROE, but unlike the other three players, it must rely on high asset turnover and leverage to make up for low margins.
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.,does not own shares in any company mentioned. The Motley Fool owns shares of Heartland Payment Systems.Motley Fool newsletter serviceshave recommended buying shares of Visa, Discover Financial Services, and Heartland Payment Systems. 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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