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 Mead Johnson Nutrition (NYS: MJN) 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?
Mead Johnson Nutrition
J.M. Smucker (NYS: SJM)
Herbalife (NYS: HLF)
ConAgra Foods (NYS: CAG)
Source: S&P Capital IQ.
Because Mead Johnson offers a negative leverage ratio (negative equity), its ROE is not measurable. However, its net margins are much higher than those offered by industry peers, and its asset turnover is the second highest of the listed companies. Herbalife's nearly 80% ROE particularly stands out, with net margins that are still high compared to its peers and an asset turnover and leverage ratio far higher than the other listed companies.
While Mead Johnson Nutrition only went public in 2009, it has a century of experience in making infant and child nutrition products under Bristol-Myers Squibb (NYS: BMY) . Since then, the company has produced solid profits, with 60% of its revenues coming Asia and Latin America, which provides investors the benefit of gaining exposure to those growing markets.
While Mead Johnson has to compete against Abbott Laboratories (NYS: ABT) , it has weathered the competition well, especially since Abbott's Similac recall last year, which lost the company approximately $100 million in revenue.
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.The Motley Fool owns shares of Abbott Laboratories.Motley Fool newsletter serviceshave recommended buying shares of Abbott Laboratories. 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.
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