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 McKesson (NYS: MCK) 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?
AmerisourceBergen (NYS: ABC)
Cardinal Health (NYS: CAH)
Owens & Minor (NYS: OMI)
Source: S&P Capital IQ
McKesson's return on equity falls in the middle of the pack compared to its industry peers, which all offer reasonably attractive returns on equity. Its net margins, asset turnover, and leverage ratio are also fairly comparable to those belonging to the other listed companies. But you'll notice the slim-jim margins on all these peers, as they have to rely on very high asset turnover and high leverage to generate those returns on equity.
McKesson's competitive advantage largely lies in the fact that it, along with Cardinal Health and AmerisourceBergen, dominates its market of wholesale pharmaceutical distribution, which makes it difficult for new competitors to get into their market.
Also, while recent health-care reform has brought uncertainty into the health-care sector as a whole, McKesson may stand to gain from some of these changes. For example, as the number of newly insured patients rises, McKesson will have more potential customers for its generic drugs, which tend to produce higher profit margins than brand-name drugs produced by Pfizer and Merck.
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