How Does Teck Resources Really 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.
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.
Let's see what the DuPont formula can tell us about Teck Resources (NYS: TCK) and a few of its sector and industry peers:
Return on Equity
Cliffs Natural Resources (NYS: CLF)
Cameco (NYS: CCJ)
Walter Energy (NYS: WLT)
Source: Capital IQ, a division of Standard & Poor's.
The companies here all exhibit strong net margins, but Teck's strong 18.2% showing still runs below other players in the resource sector. Given that it runs with lower leverage than other players, it could probably boost ROE with more debt financing. Walter leads this group in ROE, even without the highest margins, by using more leverage. And Cliffs puts up a similar showing with a high margin, asset turnover, and a good chunk of leverage. Cameco's lower asset turnover and leverage result in a less attractive 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. If you'd like to add these companies to your watchlist, or set up a new one, just click here.
At the time this article was published We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.Jim Royal, Ph.D.,does not own shares in any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of Walter Energy. 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.
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.