It is understandable for investors to feel as though they are suffering from information overload. There are literally thousands of stocks and bonds trading on exchanges all over the world, thousands of mutual funds, and thousands more etfs. It can be very difficult to perform research on all the companies in an industry in a time-effective manner. Fortunately, there is a quick method to allow an investor to perform a comparables analysis on the return on equity.
The DuPont formula is a formula that allows an investor to quickly break down a company’s return on equity into three parts to easily identify the source of the firm’s returns. This is an excellent way to do comparables analysis between competing companies to determine how each is earning most of its returns and profitability. The DuPont formula is named after the DuPont Corporation, which pioneered the use of this formula in the 1920s. The formula is:
Return on Equity = (Net Margins)(Asset Turnover)(Leverage Ratio)
The return on equity indicates how much return a company is generating for each dollar of shareowner’s equity that has been invested. High net margins indicate that a company has a superior ability to get customers to pay more for its products than it costs to produce them. Asset turnover is a measure of efficiency; a high asset turnover indicates that a company is more efficiently using its assets to generate revenues. A high leverage ratio indicates that a company is relying on debt to generate much of its profits – it is leveraging itself to juice its returns.
As a general rule, higher numbers are better, but beware of high values in the leverage ratio. While leverage can indeed be used to generate returns, too much debt can prove problematic. If a company has a high leverage ratio, particularly in comparison to its peers, then it is a good idea to investigate further to determine if that debt is sustainable.
I decided to use this formula to examine some of the offshore drilling companies (all figures are TTM):
Source: ROE and Asset Turnover obtained from Fidelity. Net Margins are from Motley Fool CAPS.
As should be immediately obvious, SeaDrill (NYSE:SDRL) and Diamond Offshore (NYSE:DO) have by far the best returns out of their competitors. However, they are generating these profits in different ways.
As I have written about before (here and here), SeaDrill is an excellent offshore oil drilling company. This analysis provides further insight into how it is generating its best of breed returns. The net profit margin is a healthy 30% (CapitalIQ has the margin at 33.6%), which is largely comparable to the margins of the other offshore drillers. The asset turnover, a measure of efficiency, is the lowest of its peers. That tells us that at this time, SeaDrill is not using its great assets very efficiently. Once we see the leverage ratio however, we can see where SDRL is generating its profits. It is by far the most heavily leveraged company in this industry. As I described in my previous article, I do not believe this to be a problem at this time, but it is still something that potential investors will be well advised to keep in mind.
Diamond Offshore provides an interesting contrast. Unlike SeaDrill, its returns are not juiced by leverage – but the DuPont analysis does provide some excellent insight into how it achieves returns nearly as good. Diamond Offshore’s net profit margin is a respectable 29%, about average for the industry. Their leverage is largely in line with its peers. DO’s competitive advantage is efficiency. Its asset turnover of 52% is significantly better than any of the other offshore drilling companies listed here.
The DuPont formula is no substitute for proper, indepth due diligence but it is a handy tool that can be used by investors looking to compare a number of companies quickly. It can also help alert the investor to potential competitive advantages or problems with a given firm. In this case, it has alerted me to a possible opportunity – I intend to begin some research on Diamond Offshore to figure out how it is so much more efficient than its competitors.
Disclosure: I am long SDRL.
Disclosure: I am long SDRL.