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 Whole Foods (NAS: WFM) 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?
Whole Foods Market
Source: S&P Capital IQ
Kroger (NYS: KR) has returns on equity more than 10 percentage points higher than Whole Foods', which comes in second in that category. Kroger has the second highest leverage ratio, and a much higher asset turnover, than that of the other listed companies, but it has net margins that are less than half of those offered by Whole Foods. Whole Foods focuses on higher net margins, but its leverage ratio is by far the lowest, leading to an adequate ROE. Safeway (NYS: SWY) has an ROE not far behind Whole Foods', but uses twice as much leverage to get there. SUPERVALU (NYS: SVU) has returns on equity in the negative numbers, due to its negative net margins and exacerbated by its astronomical leverage ratio.
Whole Foods is famous for its success in changing the supermarket industry by creating a chain of popular stores that provide a huge range of natural and organic foods, which has led competitors like Wal-Mart (NYS: WMT) and Kroger to increase their range of organic products. Wal-Mart's "great for you" labels are the most recent manifestation of this. Whole Foods has also succeeded in increasing consistent revenue and profit growth while competitors like SUPERVALU and Safeway have struggled to maintain their sales levels. However, Whole Foods faces increasing competition from companies like Trader Joe's and The Fresh Market, which have found some success in taking advantage of the increasing popularity of natural and organic foods.
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.
If you'd like to add these companies to your watchlist, or set up a new one, just click below:
Add Wal-Mart Stores to My Watchlist.
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At the time thisarticle was published Jim Royal, Ph.D.,owns shares in SUPERVALU.The Motley Fool owns shares of Whole Foods Market, Wal-Mart Stores, and SUPERVALU.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart Stores, Whole Foods Market, and The Fresh Market.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Wal-Mart Stores.Motley Fool newsletter serviceshave recommended buying calls in SUPERVALU. 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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