How Does Pfizer Boost Its 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 Pfizer (NYSE: PFE  ) 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?

Company	Return on Equity	Net Margin	Asset Turnover	Leverage Ratio
Pfizer	11.4%	16.7%	0.35	2.17
Merck (NYSE: MRK  )	7.5%	8.8%	0.45	1.85
Celgene (Nasdaq: CELG  )	20.8%	24.1%	0.57	1.52
Sanofi (NYSE: SNY  )	8.9%	14.5%	0.26	2.38

Source: S&P Capital IQ

Pfizer's returns on equity are largely achieved through its strong net margin and leverage ratio. But its low asset turnover makes Pfizer turn in a limp 11.4% return on equity. Celgene has the highest return on equity of the listed companies, more than 9 percentage points above Pfizer's. These are largely achieved with a net margin that dwarfs those offered by its industry peers and stronger asset turnover than the other listed companies, even without using high leverage.

Pfizer currently offers an attractive 3.7% dividend. However, now that its patent for Lipitor has expired, the company faces potential competition from companies like Watson Pharmaceuticals (NYSE: WPI  ) , Teva Pharmaceutical (Nasdaq: TEVA  ) , and Mylan (Nasdaq: MYL  ) , which produce generic drugs. None of that increased competition will be good for long-term dividend growth.

But not all is lost for the blue-pill maker. Pfizer successfully defended its patent to prevent other companies from selling generic versions of Viagra until 2019. This is a big win, since Viagra makes up about 3% of Pfizer's revenue and even more on the bottom line, since the product likely has high margins.

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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