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 Buffalo Wild Wings (NAS: BWLD) 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.
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?
Buffalo Wild Wings
Jack in the Box
Source: S&P Capital IQ
Panera Bread (NAS: PNRA) has the highest returns on equity of the listed companies, with the highest net margin, even without using more leverage than its peers. Buffalo Wild Wings has the next highest ROE, with the second-highest net margin and similar asset turnover and leverage. Jack In the Box (NAS: JACK) has returns on equity a few percentage points behind Buffalo Wild Wings. It compensates for low margin by using high leverage. BJ's Restaurants (NAS: BJRI) has the lowest ROE, due in part to low asset turnover.
While the restaurant industry as a whole has suffered from increases in the price of raw ingredients due to the rise in crop prices, Buffalo Wild Wings has the advantage of relying heavily on chicken, which has recently been at low prices due to oversupply problems in that area. This gives it an advantage over other restaurants like McDonald's, Domino's, and Papa John's, which rely more heavily on the higher priced raw ingredients.
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 shares in McDonald's.The Motley Fool owns shares of Panera Bread, Domino's Pizza, Buffalo Wild Wings, and Papa John's International.Motley Fool newsletter serviceshave recommended buying shares of McDonald's, Buffalo Wild Wings, and Panera Bread.Motley Fool newsletter serviceshave recommended writing covered calls on Buffalo Wild Wings. 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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