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 ResMed (NYS: RMD) 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
Varian Medical Systems
Source: S&P Capital IQ.
Varian Medical Systems (NYS: VAR) offers returns on equity more than double that of the other listed companies, which results from an asset turnover far higher than the other companies, and without high leverage. ResMed has the second highest returns on equity, with net margins several percentage points higher than the other companies, by focusing on higher margins despite having the lowest asset turnover here. CONMED (NAS: CNMD) has returns on equity that are less than half of ResMed's, with the biggest difference being net margin. Accuray (NAS: ARAY) has returns on equity in the low negative numbers due to its negative net margins.
ResMed is one of the dominant providers of CPAP machines, which are used to treat sleep apnea, a medical condition in which a brief collapse in the airway causes individuals to momentarily stop breathing, which wakes them up. The growing problem of obesity, one of the leading causes of sleep apnea, has led to a growth in this market.
Accuray provides an innovation in radiological treatment products called CyberKnife, which helps patients avoid more invasive surgeries. However, Varian and Siemens both have products that compete with CyberKnife.
CONMED sells surgical equipment and devices useful in patient monitoring and minimally invasive surgeries. CONMED recently formed a distribution and marketing agreement with the Musculoskeletal Transplant Foundation (MTF). This agreement makes CONMED the exclusive worldwide marketing representative for MTF's sports medicine allograft tissues, and it allows the company to serve as the worldwide distributor for its platelet-rich plasma, which heals patients by using their own blood components. This agreement entitles the company to $63 million in upfront payments and has the possibility of bringing in $84 million over the next four years.
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.Motley Fool newsletter serviceshave recommended buying shares of Intuitive Surgical. 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.