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.
So in this series we let the DuPont do the work. Let's see what the formula can tell us about Union Pacific (NYS: UNP) and a few of its peers.
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.
So what does DuPont say about these four companies?
Canadian National Railway (NYS: CNI)
CSX (NYS: CSX)
Norfolk Southern (NYS: NSC)
Source: S&P's Capital IQ.
Union Pacific's 17.2% ROE is the lowest of the listed companies. Its net margins and leverage ratio are the second-lowest of the listed companies, while its asset turnover is the highest. As you can see, the net margins in railroad have been pretty high, helping to lead to high ROE despite low asset turnover.
With the recovering economy, these companies have been able to benefit from the fact that organizations need to ship more materials and products. For example, Norfolk Southern has reported an increase in its coal and automotive shipments and CSX has reported an increase in its freight volume. Also, increases in energy costs do not hurt profit margins for railroads as much as they do for trucking companies, so Union Pacific and its peers will show some resilience even in troubling times.
There are other reasons to find Union Pacific attractive aside from the advantages held by the current transportation sector. It offers a 2.3% dividend yield, which is equal to Norfolk Southern's current yield and better than the yields offered by Canadian National Railway or CSX. However, CSX and Norfolk Southern have offered better past dividend growth than Union Pacific.
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.
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At the time thisarticle 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 Canadian National Railway. 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.