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 AgFeed Industries (NAS: FEED) and a few of its sector and industry peers:
Return on Equity
Zhongpin (NAS: HOGS)
Pilgrim's Pride (NYS: PPC)
Hormel Foods (NYS: HRL)
Source: Capital IQ, a division of Standard & Poor's.
AgFeed posts a negative return on equity, despite having asset turnover and leverage that are about in line with peers'. That's clearly due to the negative net margin, which also included an impairment of goodwill in the trailing 12 months. Zhongpin and Hormel post similarly solid returns on equity in similar ways: modest net margins, with comparable asset turnover and leverage. While Pilgrim's has much higher leverage and asset turnover, its ROE is pulled into the red by negative net margin.
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, click on any of the links below:
Add AgFeed Industries to My Watchlist.
Add Pilgrim's Pride to My Watchlist.
Add Hormel Foods to My Watchlist.
Add Zhongpin to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D.,does not own shares in any company mentioned.Motley Fool newsletter serviceshave recommended writing puts in Zhongpin. 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.