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 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 companies?
Return on Equity
|Johnson & Johnson
|Abbott Labs (NYSE: ABT )
|Eli Lilly (NYSE: LLY )
Source: S&P Capital IQ.
Eli Lilly has by far the highest returns on equity of these companies, with the highest net margins, the highest asset turnover, and the second highest leverage ratio. Abbott Labs uses comparable leverage, but its lower margin and asset turnover lead to a lower ROE, more than 13 percentage points behind Eli Lilly's. Johnson & Johnson has the third highest returns on equity, pulled down by relatively lower leverage
Until 2009, Johnson & Johnson offered annual sales gains for more than 75 years in a row. The company's streak ended after the patents on some of its most important drugs expired combined with a weak economy, which reduced demand for its medical devices. In addition, the company suffered from product recalls, which will probably hit J&J the hardest in the long term because they had customers turning to competitors to fill their drug needs.
The competition for J&J is likely to get stiffer because of a joint venture between Teva Pharmaceutical (Nasdaq: TEVA ) and Procter & Gamble (NYSE: PG ) to produce and sell over-the-counter medicines. Not only does this joint venture bring in new product competition, but it also combines the strengths of both companies.
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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