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 TJX (NYS: TJX) 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?
Source: S&P Capital IQ
TJX has more than double the returns on equity of the other listed companies, with asset turnover more than double that of Saks (NYS: SKS) , which throws out the second highest numbers in that category. TJX also has the highest net margins and runs with a good bit of leverage. Macy's (NYS: M) has the second highest ROE. While its net margin is the second lowest of the listed companies, it uses a much higher leverage ratio to bump up ROE. Kohl's (NYS: KSS) has the third highest ROE, but uses much lower asset turnover and somewhat less leverage. Saks has a low ROE, well below these retail rivals, due largely to low margin and leverage.
TJX offers products from celebrated, expensive brands at a discount by buying excess inventory off of these high-end businesses. This business model has made the company more resilient during the recession due to the fact that consumers do not need as much disposable income to afford the products sold at Marshall's, TJ Maxx, and its other stores. While TJX is dominant within this area of retail, it faces competition from stores like Big Lots (NYS: BIG) , DSW, Ross Stores, and Overstock.com, which use a similar business model.
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 The TJX Companies to My Watchlist.
Add Saks to My Watchlist.
Add Ross Stores to My Watchlist.
Add Overstock.com to My Watchlist.
Add Macy's to My Watchlist.
Add Kohl's to My Watchlist.
Add DSW to My Watchlist.
Add Big Lots to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D.,does not own shares in any company mentioned.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.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.