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.
So in this series we let the DuPont do the work. Let's see what the formula can tell us about Apple (NAS: AAPL) and a few of its peers.
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.
So what does the DuPont say about these four companies?
Dell (NAS: DELL)
Hewlett-Packard (NYS: HPQ)
Seagate Technology (NAS: STX)
Source: S&P Capital IQ.
Apple, along with Dell, offers an extremely high return on equity at above 40%, and that's especially high given the massive amount of cash and securities that it holds. The other two listed companies have less than half those returns. Apple also has much higher margins -- almost 34% -- than the other listed companies. Its asset turnover, on the other hand, is more comparable to its industry peers, and it has the lowest leverage ratio of the four.
Apple's lack of dividend makes it a less desirable investment for conservative investors, but with its huge cash flow, it could certainly follow Hewlett-Packard and Seagate Technology's lead in offering a dividend, with the former giving a 1.7% dividend yield and the latter offering a 4.5% yield.
Apple stands out from the competition for promoting innovation, which has helped it maintain high sales and cash flow even during tough economic times. The massive popularity of its iPhone has helped Apple to get approximately $600 per phone from customers and carriers like AT&T (NYS: T) , Verizon (NYS: VZ) , and Sprint Nextel. We've seen these companies grow to dominate the top of the wireless market, due in part to their ability to offer the most popular smartphones on the market (case in point: the iPhone).
Even with all of these advantages, investors would do well to pay attention to the way in which the products produced by competitors like Amazon.com (NAS: AMZN) affect the sales of Apple's products. If Apple is going to continue to corner the market, it needs to continue to brand itself strongly so customers maintain their preferences for its products and continue to innovate
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 Apple.Motley Fool newsletter serviceshave recommended buying shares of Amazon.com, Dell, and Apple; and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.