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.
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. But too much debt can sink a company, so beware of companies with very high leverage ratios.
Let's see what the DuPont Formula can tell us about Terra Nitrogen (NYS: TNH) and a few of its sector and industry peers:
Return on Equity
Mosaic (NYS: MOS)
PotashCorp (NYS: POT)
Scotts Miracle-Gro (NYS: SMG)
Source: Capital IQ, a division of Standard & Poor's.
Terra Nitrogen leads these rivals in ROE largely because of high net margin and asset turnover without using much leverage. But the other players have solid returns on equity, too. Mosaic and PotashCorp both achieve strong ROE, but PotashCorp edges its rival with a higher margin and more leverage. Scotts beats both of these companies, however, despite a much lower margin.The company uses higher asset turnover and much more leverage to plump up its ROE.
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. And if you'd like to, add these companies to your Watchlist.
At the time thisarticle was published Jim Royal, Ph.D.,owns no shares in any company mentioned. 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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