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.
In this series, we let the DuPont do the work. Let's see what the formula can tell us about Lockheed Martin (NYS: LMT) 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.
What does DuPont say about these four companies?
Return on Equity
Source: S&P's Capital IQ
Lockheed Martin has by far the highest returns on equity of the listed companies. How does Lockheed do it? With a leverage ratio more than five times higher than any of the other listed companies, despite having a substantially lower margin. Raytheon (NYS: RTN) has the second highest ROE, with the second highest leverage ratio, which is still far higher than the leverage of the other two companies. ManTech (NAS: MANT) and AeroVironment (NAS: AVAV) have similar ROEs, despite ManTech's margin being half of its peer's. To offset this, ManTech uses higher asset turnover and more leverage.
While Lockheed Martin has faced tough economic times for defense contractors lately, it has fared reasonably well, despite budget cuts. However, the company has faced some setbacks due to this tough environment. For example, the Department of Defense decided to postpone part of its F-35 purchase, and the company faces threats of other countries canceling or deferring their orders, as well. Lockheed has had to respond to these challenges by looking for growth in other areas.
Some of these attempts have been more successful than others. While Lockheed hopes to win a contract to develop a Joint Light Tactical Vehicle, for example, it -- like competitors Navistar and General Dynamics -- has not managed to develop an appealing prototype. Lockheed has some hope, however, of seeing growth in its F-16 program, due to the fact that the government is looking for alternatives to spy planes developed by Northrop Grumman (NYS: NOC) , which have been having problems.
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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The article How Does Lockheed Martin Boost its Returns? originally appeared on Fool.com.
Jim Royal has no positions in the stocks mentioned above. The Motley Fool owns shares of Lockheed Martin, ManTech International, Northrop Grumman, and Raytheon Company. Motley Fool newsletter services recommend AeroVironment. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.