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 Peabody Energy (NYS: BTU) and a few of its sector and industry peers.
Return on Equity
Arch Coal (NYS: ACI)
CONSOL Energy (NYS: CNX)
Patriot Coal (NYS: PCX)
Source: S&P Capital IQ.
Peabody leads this group in return on equity, with the highest margin and asset turnover, while using the least leverage. CONSOL ups the leverage, but its asset turnover and margin are lower. Arch puts up still lower numbers in each category, leading to a lackluster ROE. Although Patriot's asset turnover is at or near the top compared with its peers', its negative margin draws 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 follow the links:
Add Patriot Coal to My Watchlist.
Add CONSOL Energy to My Watchlist.
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Add Arch Coal to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., owns no shares in any company mentioned. 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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