How Does Reynolds American Boost Its Returns?

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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 Formula do the work. Let's see what it can tell us about Reynolds American (NYS: RAI) 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

Reynolds American22%16.5%0.512.61
Lorillard (NYS: LO) NM25.1%1.41(3.63)
Altria Group (NYS: MO) 75.9%20.4%0.458.32
Philip MorrisInternational (NYS: PM) 258%27.6%0.8810.25

Source: S&P Capital IQ. NM = not measurable.

Philip Morris has by far the highest returns on equity of these companies, with the highest net margins, the highest leverage ratio, and the second highest asset turnover. Altria also has very high returns on equity, but its numbers in all three categories, though still high, fall well short of what Philip Morris puts up. Reynolds American also delivers a respectable ROE. Of these major tobacco players, Reynolds has the lowest net margins and the second lowest asset turnover and leverage ratio. Lorillard's ROE is not meaningful because of its negative leverage ratio. However, it has the second highest net margins and the highest asset turnover and would show a favorable ROE if it had any equity in the business.

Along with the rest of the tobacco industry, Reynolds American has faced pressure from increases in regulation. The companies have managed to maintain big profits all the same, but the fear of lawsuits and other attacks to the industry poses the potential to scare away investors.

Reynolds has responded to government pressures by cooperating with peers such as Lorillard and Vector Group (NYS: VGR) to file a suit with the goal of preventing further requirements for more graphic warnings on their cigarette packaging. The tobacco industry achieved some success in this area in November, at which point the court ruled that the proposed restrictions violated free-speech rights. The court also ruled that the government could not enforce additional labeling requirements until the lawsuit ends.

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 this article was published Jim Royal, Ph.D.,owns shares of Philip Morris International. The Motley Fool owns shares of Altria Group and Philip Morris International.Motley Fool newsletter serviceshave recommended buying shares of Philip Morris International. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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