How Do These Software Companies Boost Their Returns?
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 QLIK Technologies (NAS: QLIK) 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?
|International Business Machines||73.1%||14.8%||0.93||5.30|
Source: S&P Capital IQ
International Business Machines (NYS: IBM) has return on equity -- above 70% -- that are far higher than that of the other listed companies. The reasons: Its leverage ratio is more than double that of the other listed companies, and net margins are also far higher than those of the listed competitors. Its asset turnover, on the other hand, is the second lowest. Acutate (NAS: BIRT) and MicroStrategy (NAS: MSTR) both have returns on equity in the 11% range, but Actuate focuses on higher margins, while MicroStrategy puts up twice the asset turnover. Qlik has the lowest returns on equity of the listed competitors, with the lowest net margins and leverage ratio, but the second highest asset turnover.
Qlik is involved in the fast-growing business intelligence market, and has seen substantially more growth than competitors Acutate and MicroStrategy. If it continues its growth pace, it should be in a position to gain a long-term competitive advantage over other companies in the sector. International Business Machines, which is best known for its hardware, has started to dedicate more energy to providing software and services that can be used with its hardware. This has helped it develop a competitive advantage over other hardware companies, such as Hewlett-Packard (NYS: HPQ) , Dell, and Oracle. IBM has also been working to gain more exposure to international markets, with nearly two-thirds of its revenue coming from overseas.
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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- Add Dell to My Watchlist.
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At the time this article was published Jim Royal, Ph.D.,does not own shares in any company mentioned.The Motley Fool owns shares of Oracle, Qlik Technologies, and International Business Machines.Motley Fool newsletter serviceshave recommended buying shares of Qlik Technologies.Motley Fool newsletter serviceshave recommended writing covered calls in Dell. 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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