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 Career Education (NAS: CECO) 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?
American Public Education
ITT Educational Services
Source: S&P's Capital IQ.
ITT Educational Services (NYS: ESI) offers a 207.3% return on equity, which is more than six times higher than the second highest ROE, which is American Public Education (NAS: APEI) , with a 34.3% ROE. ITT achieves its high ROE through net margins, asset turnover, and a very high leverage ratio -- more than 2.5 times higher than any of the other companies. American Public Education has the second highest net margins and asset turnover, and has leverage ratios comparable to those of DeVry (NYS: DV) and Career Education. DeVry still manages net margins above 10% and leverage ratios comparable to everyone's except ITT but has the lowest asset turnover. Career Education has the lowest ROE, with the lowest net margins and the second lowest asset turnover.
Career Education has faced challenges coming from controversies in the for-profit education industry. After rising concerns about poor student loan repayment rates, the Government Accountability Office investigated recruitment procedures at for-profit schools and found evidence of fraud and deception in those procedures. As a result, the government threatened to no longer offer subsidized student loans to students going to these schools. However, when the final regulations came out in June of last year, they did not have the bite that was expected. This was a particularly big relief for Strayer Education (NAS: STRA) and Corinthian Colleges, which were particularly concerned about the new regulations.
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 American Public Education.Motley Fool newsletter serviceshave recommended buying shares of American Public Education. 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.
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