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 Terra Nitrogen (NYS: TNH) 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
Mosaic (NYS: MOS)
PotashCorp (NYS: POT)
Scotts Miracle-Gro (NYS: SMG)
Source: S&P Capital IQ.
Terra Nitrogen's returns on equity dwarf its industry peers. Its asset turnover is double that of the second highest numbers in that category, and its net margins come in a close second after PotashCorp. Terra Nitrogen's leverage ratio, on the other hand, is significantly lower than that of the other companies.
Terra Nitrogen and its industry peers greatly benefited from higher crop prices last year, which gave farmers more money and more incentive to buy fertilizers and farming equipment to increase their crop yields. While Terra Nitrogen's continued success relies on the continuation of these favorable market conditions, CF Industries (NYS: CF) , Terra Nitrogen's majority owner, expects a great deal of corn planting this year, which will be good for the company at least in the short term. Terra's advantage over industry peers largely lies in its lower expenses, which result from its use of nitrogen-based fertilizers over more expensive mined potash and phosphates.
Monsanto has benefitted from the same positive market conditions, but its profits have suffered a great deal because of generic competition for its Roundup herbicide, which had previously brought in a great deal of revenue. In addition, the failure of its corn to resist attacks from the Western corn rootworms it had been designed to resist opens it to competition from companies that can offer products that better resist pests.
Scotts Miracle-Gro produces fertilizers, insecticides, and other products popular among individuals and commercial nurseries and greenhouses. Their products are designed to control pests and weeds and to fertilize plants. The company also markets its products to those who grow certain specialty crops. Because Scotts primarily sells to individuals, it suffers more from the struggling retail market in the sluggish economy. In fact, two thirds of the company's revenue in 2010 came from sales through retailers such as Wal-Mart, Lowe's, and Home Depot. This has pushed Scotts Miracle-Gro to look for growth in other areas, including the medical-marijuana market.
PotashCorp has shown a strong pattern of growing its revenue, with a five-year average revenue growth rate above 20% and growth over 50% since last year. It has been able to do this by pushing its products in emerging markets. And like the other businesses, its recent success is partially attributable to the major increase in crop prices last year.
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.,owns no shares in any company mentioned. The Motley Fool owns shares of Wal-Mart and CF Industries.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart, Lowe's, Home Depot, and Scotts Miracle-Gro, writing covered calls in Lowe's, and creating a diagonal call position in Wal-Mart. 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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