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 DPL (NYS: DPL) and a few of its sector and industry peers:
Return on Equity
Alliant Energy (NYS: LNT)
Ameren (NYS: AEE)
CMS Energy (NYS: CMS)
Source: Capital IQ, a division of Standard & Poor's.
With asset turnover in a pretty narrow range, much of the variance in ROE will be attributable to differences in leverage and margin. DPL leads this group in ROE, with a solid margin and high asset turnover, even while using leverage that is comparable to that of peers. CMS achieves just half the net margin, but its much-higher leverage ratio keeps its ROE in the teens. Alliant gets better margins than CMS, but lower leverage shrinks its overall ROE. Ameren's low net margin hurts its relative performance, since leverage and asset turnover are broadly in line with that of 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, click on any of the links below:
Add DPL to My Watchlist.
Add Alliant Energy to My Watchlist.
Add CMS Energy to My Watchlist.
Add Ameren to My Watchlist.
At the time thisarticle was published 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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