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 Formula do the work. Let's see what the formula can tell us about Teck Resources (NYS: TCK) 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
Cliffs Natural Resources (NYS: CLF)
Cameco (NYS: CCJ)
Walter Energy (NYS: WLT)
Source: S&P Capital IQ.
Cliffs Natural Resources has the highest ROE of these companies, with the highest net margins and asset turnover, and the second highest leverage ratio. Walter Energy has the second highest ROE even though it has the lowest net margins. This is largely due to its leverage ratio, which dwarfs that of the other companies. Teck Resources has the next highest ROE, but it is less than half of that offered by Cliffs Natural Resources, despite having a comparable margin. Tech Resources' asset turnover is closer to that offered by Cameco, which is the lowest of these companies. Teck also has the second lowest leverage ratio.
The success of most of Teck Resources' products is tied to the global economy. Along with Freeport-McMoRan Copper & Gold and Southern Copper, it is involved in copper production, for which sales growth depends on growth in infrastructure and housing in emerging markets. Along with Alpha Natural Resources and Arch Coal, Teck produces metallurgical goal, which has recently been a high-growth area. While Teck has seen some good opportunities in these areas, it has also faced several challenges associated with the financial crisis, which forced it to sell its stake in Hemlo Mines for much less than it was worth.
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 Walter Energy to My Watchlist.
Add Teck Resources to My Watchlist.
Add Southern Copper to My Watchlist.
Add Freeport-McMoRan Copper & Gold to My Watchlist.
Add Cliffs Natural Resources to My Watchlist.
Add Cameco to My Watchlist.
Add Alpha Natural Resources to My Watchlist.
Add Arch Coal to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D.,owns no shares in any company mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold.Motley Fool newsletter serviceshave recommended buying shares of Walter Energy. 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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