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 Johnson & Johnson (NYSE: JNJ ) 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
|Johnson & Johnson
|Abbott Laboratories (NYSE: ABT )
|Eli Lilly (NYSE: LLY )
Source: S&P Capital IQ.
Johnson & Johnson's returns on equity fall in with Abbott Labs, while Eli Lilly offers a very high ROE. Johnson & Johnson's leverage ratio and asset turnover are at the bottom of the range seen among the three companies. All three net margins are quite high.
Johnson & Johnson is a nice play for conservative investors as an all-purpose health stock producing health-related consumer goods, medical devices, and pharmaceuticals.
Johnson & Johnson has struggled over the past couple of years due to recalls that cost the company $900 million in sales and a weak economy preventing patients from having elective medical procedures. The recalls have caused customers to turn to competitors like Procter & Gamble and Kimberly-Clark. While it has struggled to grow much over the past couple of years due to recalls, that may give investors an opportunity to buy some shares at a low price. It is likely that these recalls will result in continued slow growth as the company works to win those customers back.
Industry peers in the medical device market like Medtronic (NYSE: MDT ) and Intuitive Surgical (Nasdaq: ISRG ) have also suffered from weak sales in the face of the fragile economy.
Despite the slow growth in recent years, Johnson & Johnson has a strong track record of bouncing back from tough times (as evidenced by its recovery from the Tylenol recall in 1982), and so the company's current struggles provide a nice opportunity for investors to buy at low prices. Also, its 3.6% dividend yield makes the company a strong pick for those seeking dividend income.
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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