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 Visa (NYS: V) 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?
Discover Financial Services
Heartland Payment Systems
Source: S&P's Capital IQ.
While MasterCard (NYS: MA) has the second lowest net margins and leverage ratio of the listed companies, and the second highest asset turnover, it still has the highest return on equity of the listed companies. Discover Financial Services (NYS: DFS) has an ROE just 4 percentage points behind MasterCard's, largely attributable to its extremely high leverage ratio. Heartland Payment Systems (NYS: HPY) has the next highest returns on equity, but they are 8 percentage points lower than Discover's returns. Heartland focuses on high asset turnover and leverage but earns tiny net margins. Visa has the lowest ROE of the listed companies, even though it earns the highest net margins. Its ROE is hurt by relatively lower asset turnover and leverage.
Visa's huge size gives it a competitive advantage. The company has more cards than MasterCard, Discover Financial, and American Express (NYS: AXP) combined. However, Visa currently faces the challenge of building partnerships with larger companies to set up remote payment services as companies like Google and PayPal increasingly move in this direction. If Visa fails to win a large portion of these contracts, it may lose its competitive advantage. However, the company has a huge cash position and a lack of long-term debt, which puts it in a strong position to compete.
Heartland's recent quarterly earnings trounced analysts' estimates, as the company ramped up processing volumes. Heartland grew revenue 13%, and more importantly projected 2012 earnings that handily beat what the experts were predicting: $1.54 per share to $1.32. In comparison, MasterCard grew last quarter's revenue at 20%, while Discover and Visa put up 23% and 13.8%, respectively.
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., does not own shares in any company mentioned. The Motley Fool owns shares of Google, Heartland Payment Systems, and MasterCard. Motley Fool newsletter services have recommended buying shares of Heartland Payment Systems, Visa, and Google. Motley Fool newsletter services have recommended creating a written covered strangle position in American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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