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 Tyson Foods (NYSE: TSN ) 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
Source: S&P Capital IQ
Hormel Foods (NYSE: HRL ) has the highest ROE of the listed companies. This is achieved largely through its net margins, which are far higher than that of the other listed companies. Its asset turnover and leverage ratio, on the other hand, are both the second lowest of the listed companies. Smithfield Foods (NYSE: SFD ) has the second highest returns on equity, with the second highest net margins and the highest leverage ratio, but the lowest asset turnover. Tyson is nearly five percentage points behind Smithfield Foods in its ROE, beating out only Sanderson Farms (Nasdaq: SAFM ) . Its net margins are below 2%, but it compensates with leverage and the highest asset turnover of the group. Sanderson's negative ROE is caused by its negative net margins.
Tyson is in the meat products business, which has recently been facing challenges associated with increases in the price of feed, which results in an increase in the price of raising animals. These high costs eat into the profit margins of Tyson and its competitors. But it gets worse. Not only were the profit margins already narrow for meat businesses due to high costs, but they are also facing oversupply problems.
While these businesses could address this problem by cutting back on production, companies like Tyson, Sanderson Farms, and Pilgrim's Pride (NYSE: PPC ) all refrain from doing so. Fellow Fool Dan Caplinger speculates they are doing so out of fear of losing market share. On the other hand, American meat companies have the opportunity to profit from recent natural disasters in Japan, which crushed the local meat supply. This not only will this help the bottom line for American companies who can export their meat to Japanese customers, but it also helps other American companies by reducing the oversupply problem in the U.S.
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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