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 Abbott Laboratories (NYS: ABT) 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 DuPont say about these four companies?
Sanofi (NYS: SNY)
Bristol-Myers Squibb (NYS: BMY)
Novartis (NYS: NVS)
Source: S&P's Capital IQ
Abbott Laboratories' returns on equity are high, but still fall near the middle of the pack compared to industry peers. Its net margins, on the other hand, are the lowest of the listed companies and it relies on more leverage than the other three companies.
Abbott Labs' growth up to this point has primarily depended on a single drug, called Humira. However, the company has recently announced its plan to split itself into two publicly traded businesses -- one focusing on pharmaceuticals and the other focusing on medical devices. This will put the resulting companies in a stronger position to compete against other companies in their niche markets, including Merck (NYS: MRK) , Pfizer (NYS: PFE) , and Medtronic (NYS: MDT) .
If the plan is successful, Abbott Labs may produce more growth than it has in the past and position itself to become a stronger competitor among industry peers. In addition, long-term investors should be attracted to Abbott's continued devotion to increasing its dividend.
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 Abbott Laboratories and Medtronic. Motley Fool newsletter services have recommended buying shares of Novartis, Pfizer, and Abbott Laboratories. 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.