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 Pfizer (NYS: PFE) 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?
Merck (NYS: MRK)
Celgene (NAS: CELG)
Sanofi (NYS: SNY)
Source: S&P Capital IQ
Pfizer's returns on equity are largely achieved through its strong net margin and leverage ratio. But its low asset turnover makes Pfizer turn in a limp 11.4% return on equity. Celgene has the highest return on equity of the listed companies, more than 9 percentage points above Pfizer's. These are largely achieved with a net margin that dwarfs those offered by its industry peers and stronger asset turnover than the other listed companies, even without using high leverage.
Pfizer currently offers an attractive 3.7% dividend. However, now that its patent for Lipitor has expired, the company faces potential competition from companies like Watson Pharmaceuticals (NYS: WPI) , Teva Pharmaceutical (NAS: TEVA) , and Mylan (NAS: MYL) , which produce generic drugs. None of that increased competition will be good for long-term dividend growth.
But not all is lost for the blue-pill maker. Pfizer successfully defended its patent to prevent other companies from selling generic versions of Viagra until 2019. This is a big win, since Viagra makes up about 3% of Pfizer's revenue and even more on the bottom line, since the product likely has high margins.
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 We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.Jim Royal, Ph.D.,does not own shares in any company mentioned.The Motley Fool owns shares of Teva Pharmaceutical Industries.Motley Fool newsletter serviceshave recommended buying shares of Teva Pharmaceutical Industries and Pfizer. 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.