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 AT&T (NYS: T) and a few of its sector and industry peers:
Sprint Nextel (NYS: S)
Verizon Communications (NYS: VZ)
Vodafone (NAS: VOD)
Source: S&P Capital IQ.
AT&T leads this peer group in ROE, despite not leading it in any individual category, scoring in the mid-range in each of the three areas. Verizon comes up second, largely due to a much lower net margin, since asset turnover and leverage are similar to AT&T. Vodafone is focused on higher margins, and its much lower asset turnover and leverage pull down its ROE. Sprint Nextel has the highest leverage and asset turnover, ultimately making its ROE look even more negative.
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 shares of Vodafone. Motley Fool newsletter services have recommended buying shares of Vodafone Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.