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 SanDisk (NAS: SNDK) 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?
Return on Equity
STEC (NAS: STEC)
Seagate Technology (NAS: STX)
Western Digital (NYS: WDC)
Source: S&P Capital IQ.
SanDisk has the highest return on equity of these companies, and it does so largely through net margins that dwarf the rest. Its asset turnover, on the other hand, is the lowest of these companies, and its leverage ratio falls in the middle of the pack. Seagate's returns on equity come in a close second, but its returns are largely achieved by a leverage ratio that is more than double that of the other companies.
STEC and Western Digital's ROEs are both in the 14% range. STEC's net margins are the second highest of these companies, as is its asset turnover. Its leverage ratios, on the other hand, are much lower than the others.
Much of SanDisk's recent success can be attributed to the growing popularity of smartphones, which create a demand from smartphone makers for its flash memory. And it is likely that this demand will only increase with the growing popularity of tablets. However, SanDisk does face some competition in this area from companies like Micron Technology (NAS: MU) , which also produces flash memory.
But SanDisk's success does not rely entirely on the demand for its flash memory. It, along with STEC, also produces solid-state storage, which puts it in a good position to benefit from the possible change in demand from optical and magnetic storage to solid-state storage.
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.
At the time thisarticle was published Jim Royal, Ph.D.,owns no shares in any company mentioned. The Motley Fool owns shares of Western Digital. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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