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 Waste Management (NYS: WM) and a few of its sector and industry peers:
Return on Equity
Casella Waste Systems (NAS: CWST)
Republic Services (NYS: RSG)
Veolia Environnement S.A. (NYS: VE)
Source: S&P Capital IQ.
Waste Management puts a solid return on equity, with a margin that is in between those of its closest peers, and it runs with reasonably high leverage -- not so unusual for a company with predictable demand. In contrast, Republic Services hauls in a somewhat smaller margin, but its much lower asset turnover and leverage pull its ROE down to less than half of Waste Management's. Casella's gaudy ROE is due largely to its very high leverage and not to outstanding operational performance. Veolia also uses high leverage, but its much lower margin brings down overall 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.
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At the time thisarticle was published Jim Royal, Ph.D.,owns no shares in any company mentioned. The Motley Fool owns shares of Waste Management.Motley Fool newsletter serviceshave recommended buying shares of Republic Services, Waste Management, and Veolia Environnement and creating a write covered strangle position in Waste Management. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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