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 RPM International (NYS: RPM) 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
PPG Industries (NYS: PPG)
Albemarle (NYS: ALB)
Source: S&P Capital IQ.
PPG Industries and Albemarle beat their industry peers in returns on equity, with PPG offering 30% returns and Albemarle offering just below that. PPG's ROE performance is largely due to its leverage ratio, which is far above that of the other companies. Albemarle's ROE performance is largely due to its strong net margins, which are more than double that of any other company here.
RPM International offers an ROE that is just over half what PPG and Abermarle offer. Although its net margins are comparable with those of HB Fuller and its asset turnover is less than half of HB Fuller's, its leverage ratio is nearly triple.
These companies are all affected by the construction market, which has struggled a great deal during the Lesser Depression. RPM, however, has been able to improve its margins over the past six months despite the blow it took from the struggling economy. PPG has also been fairly resilient, with increases in its net income over the past three quarters and increases in its revenue over the past year.
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. 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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