How Does Big Tobacco Really Boost Its Returns?

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.

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. But too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's see what the DuPont Formula can tell us about Altria (NYSE: MO  ) and a few of its sector and industry peers.

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Altria

82.4%

24.0%

0.44

7.83

British American Tobacco (AMEX: BTI  )

36.0%

19.3%

0.55

3.12

Reynolds American (NYSE: RAI  )

20.4%

13.0%

0.49

2.70

Philip Morris International (NYSE: PM  )

133.1%

26.7%

0.78

6.18

Source: Capital IQ, a division of Standard & Poor's.

The returns on equity in tobacco are simply staggering. Altria puts out an eye-popping ROE, but even that is surpassed by spinoff Philip Morris. Both have similar margins, but Philip Morris pulls ahead with a much higher asset turnover. British American and Reynolds have smaller margins and less leverage than the Marlboro Men; their margins are much lower but nonetheless attractive.

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. And if you'd like to, add these companies to your watchlist.

We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Jim Royal, Ph.D., owns shares in Philip Morris, which is a Motley Fool Global Gains selection. The Fool owns shares of Altria Group and Philip Morris. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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