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 Colgate-Palmolive (NYS: CL) 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?
Return on Equity
Clorox (NYS: CLX)
Church & Dwight (NYS: CHD)
Procter & Gamble (NYS: PG)
Source: S&P Capital IQ.
Colgate-Palmolive has an extremely high ROE, with the highest net margins and asset turnover of its industry peers and a higher leverage ratio than two of the other companies in the chart. Clorox has an even higher ROE at almost 273%, largely achieved with a whopping 43.69 leverage ratio. Its asset turnover is also the second highest of these companies. Church & Dwight and Procter & Gamble also both have respectable ROEs, using high net margins.
Colgate-Palmolive hasn't been a high growth stock recently, but it has a strong track record of maintaining its dividend even during tough times, with annual increases above 10% over the past few years. Its current 2.6% dividend yield also isn't too shabby, especially given that its 7% annual sales growth rate outperforms that of Procter & Gamble, Kimberly-Clark (NYS: KMB) , and Clorox. However, Clorox and Procter & Gamble begin to make up for their slower growth with much higher dividend yields, with Clorox offering 3.7% and Procter & Gamble offering 3.2% dividend.
However, Colgate may face some challenges ahead because of increases in the prices for its basic materials, which will force the company to find other ways to cut costs, increase its prices, or face lower profit margins.
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.
Add these companies to your watchlist:
Add Procter & Gamble to My Watchlist.
Add Kimberly-Clark to My Watchlist.
Add Clorox to My Watchlist.
Add Colgate-Palmolive to My Watchlist.
Add Church & Dwight to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D.,owns shares of P&G and Church & Dwight. The Motley Fool owns shares of Clorox.Motley Fool newsletter serviceshave recommended buying shares of Procter & Gamble and Kimberly-Clark. 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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