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 Buffalo Wild Wings (NAS: BWLD) and a few of its sector and industry peers:
Return on Equity
Buffalo Wild Wings
Panera Bread (NAS: PNRA)
Brinker International (NYS: EAT)
Jack in the Box (NAS: JACK)
Source: S&P Capital IQ.
Buffalo Wild Wings puts up a solid return on equity, with a margin that's a little lower than fast-casual rival Panera's. Otherwise, these two profitable and fast-growing concepts turn in similar asset turnover and leverage. Brinker goes them one better, putting up even higher ROE, despite a lower margin. You can see why: much higher leverage. Jack in the Box puts up asset turnover in line with peers' and uses high leverage, but its much lower net margin really crimps 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, or set up a new one, just follow the links:
Add Panera Bread to My Watchlist.
Add Jack in the Box to My Watchlist.
Add Buffalo Wild Wings to My Watchlist.
Add BJ's Restaurants to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., does not own shares in any company mentioned. The Motley Fool owns shares of Panera Bread and Buffalo Wild Wings. Motley Fool newsletter services have recommended buying shares of Buffalo Wild Wings and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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