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 Alcoa (NYS: AA) 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?
Precision Castparts (NYS: PCP)
ArcelorMittal (NYS: MT)
Commercial Metals (NYS: CMC)
Source: S&P Capital IQ.
Alcoa has the second highest ROE of the listed companies, but that's not saying too much, given the other numbers. Its net margins and leverage ratio are also the second highest of its industry peers, but its asset turnover is the lowest.
While Alcoa is dramatically outperformed by Precision Castparts in terms of ROE and margin, its revenue growth of more than 18% since last year shows promise. However, Boeing's (NYS: BA) trend of using carbon composite over aluminum could interfere with Alcoa's future profitability.
Alcoa's 1.2% dividend yield is also significantly less than Commercial Metals' and ArcelorMittal's (both of which offer 3.4% dividend yields). However, Alcoa's 10.4 P/E is also more attractive than ArcelorMittal's 12.6 P/E and Precision Castparts' 21.1 P/E. If Alcoa continues to grow its revenues and increase its return on equity, it could start to look much better relative to its industry 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.
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At the time thisarticle was published Jim Royal, Ph.D., does not own shares in any company mentioned. The Motley Fool owns shares of Arcelor Mittal. Motley Fool newsletter services have recommended buying shares of Precision Castparts. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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