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 Reynolds American (NYS: RAI) and a few of its sector and industry peers:
Return on Equity
Lorillard (NYS: LO)
Altria Group (NYS: MO)
Philip Morris International (NYS: PM)
Source: S&P Capital IQ.
Reynolds puts up a solid ROE, but its margins trail those of competitors'. If it moved leverage more in line with Altria and Philip Morris, its return on equity would look more comparable. Philip Morris has an almost unbelievable ROE, because of strong performance across all three metrics. The most striking difference between Altria and Philip Morris is asset turnover, which accounts for most of the variation in their ROE. And don't worry about that negative ROE for Lorillard: It's a result of negative equity. As you can see, the company's margin and asset turnover compare favorably with its peers'.
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 follow the links:
Add Reynolds American to My Watchlist.
Add Philip Morris International to My Watchlist.
Add Altria Group to My Watchlist.
Add Lorillard to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., owns shares of Philip Morris. The Motley Fool owns shares of Philip Morris and Altria. Motley Fool newsletter services have recommended buying shares of Philip Morris. Motley Fool newsletter services have recommended creating a bear put ladder position in Lorillard. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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