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 CenterPoint Energy (NYS: CNP) and a few of its sector and industry peers:
Return on Equity
DTE Energy (NYS: DTE)
El Paso Electric (NYS: EE)
Public Service Enterprise Group (NYS: PEG)
Source: Capital IQ, a division of Standard & Poor's.
These peers all achieve solid, if unspectacular returns on equity, but by focusing on different levers. Since asset turnover is roughly the same, differences in ROE are largely due to differences in margins and leverage. CenterPoint has the lowest margin among this group but the second-highest ROE, since it uses the most leverage. El Paso gets double the margin but uses less than half the leverage. Public Service Enterprise Group looks similar with more modest leverage and fatter margins. DTE pulls up the rear here, with margin closer to CenterPoint's but not as much leverage to drive ROE.
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, click on any of the links below:
Add CenterPoint Energy to My Watchlist.
Add Public Service Enterprise Group to My Watchlist.
Add El Paso Electric to My Watchlist.
Add DTE Energy to My Watchlist.
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. 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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