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 Eastman Kodak (NYS: EK) 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
Canon (NYS: CAJ)
Sony (NYS: SNE)
Lexmark International (NYS: LXK)
Source: S&P Capital IQ.
*Because Eastman Kodak has negative average equity, its return on equity is not measurable.
Eastman Kodak has the lowest net margins by far. While its ROE is not measurable, we have the information to determine that the company is in poor shape according to the DuPont Formula rubric. With those numbers, it's not too surprising that the company filed for bankruptcy protection earlier this week.
Lexmark International, on the other hand, offers by far the highest ROE, with net margins more than 1 percentage point higher than the second-highest performer in that category. It also has the highest asset turnover. Canon offers returns on equity that are still well into the positive numbers, despite having the lowest measurable leverage and modest asset turnover. Sony has negative returns on equity that can be attributed to its negative net margins and exacerbated by a leverage ratio much higher than that of its industry peers.
While Eastman Kodak previously had a lot of success in the camera and film business, it has failed to keep up with developments in digital technology. As a result, the company has failed to maintain a competitive advantage and the stock has declined by more than 95% since 2007. Much of its remaining value is tied up with its licensing agreements with IMAX and the possibility of success in its pending lawsuits against Apple and Research In Motion, which could pay out $1 billion in royalty payments, according to some estimates.
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.,owns no shares in any company mentioned. The Motley Fool owns shares of Apple.Motley Fool newsletter serviceshave recommended buying shares of Apple and IMAX and creating a bull call spread position in Apple. 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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