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 Transocean (NYS: RIG) 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?
Diamond Offshore Drilling
Source: S&P Capital IQ
Diamond Offshore Drilling (NYS: DO) has by far the highest returns on equity of the listed companies, with net margins more than double those of the other listed companies as well as the highest asset turnover, despite using low leverage. Nabors Industries (NYS: NBR) has the second highest returns on equity, at just above 5%. Its leverage ratio is far higher than the other listed companies, and its asset turnover is not far behind Diamond Offshore Drilling's, but its net margins are much lower than Diamond's. Noble's (NYS: NE) net margins are better, but its much lower asset turnover really hurts its ROE. Transocean has the lowest returns on equity, with returns in the negative numbers, resulting from its negative net margins.
Transocean has seen major declines in its net margins from last year. It faced a major setback about two years ago when BP began its attempt to gain recoveries from Transocean and Halliburton (NYS: HAL) to help pay for the cleanup in the Gulf of Mexico. Transocean has also had difficulty keeping up with its competitors, with a posted loss in last quarter's report.
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.The Motley Fool owns shares of Transocean and Noble. 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.