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 UnitedHealth Group (NYS: UNH) and a few of its sector and industry peers:
WellPoint (NYS: WLP)
Cigna (NYS: CI)
Aetna (NYS: AET)
Source: S&P Capital IQ.
The companies here show a narrow range of profit margins, so differences in their returns on equity are due largely to differences in asset turnover and leverage. You can see that clearly with UnitedHealth and Wellpoint, where UnitedHealth's much higher asset turnover and leverage drive its ROE well above Wellpoint's. Cigna leads this group in ROE with a focus on higher margin and leverage, despite much lower asset turnover, and Aetna looks similar but with lower margin and leverage.
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., does not own shares in any company mentioned. The Motley Fool owns shares of UnitedHealth Group. Motley Fool newsletter services have recommended buying shares of WellPoint and UnitedHealth Group; and creating a diagonal call position in UnitedHealth 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.
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