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 H.J. Heinz (NYS: HNZ) and a few of its sector and industry peers:
Return on Equity
H. J. Heinz
J&J Snack Foods (NAS: JJSF)
ConAgra Foods (NYS: CAG)
Sara Lee (NYS: SLE)
Source: S&P Capital IQ.
Heinz posts a solid return on equity with a focus on margin and leverage, while its asset turnover remains in line with peers'. Sara Lee's gaudy ROE is also due to a strong margin and high leverage. J&J and ConAgra, meanwhile, have lower margins but don't offset it with significantly higher leverage, resulting in adequate, if uninspiring, returns on equity.
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:
Add Sara Lee to My Watchlist.
Add J&J Snack Foods to My Watchlist.
Add HJ Heinz to My Watchlist.
Add ConAgra Foods to My Watchlist.
At the time thisarticle was published We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.Jim Royal, Ph.D.,owns no shares in any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of H.J. Heinz. 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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