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 Union Pacific
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, as 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
Canadian National Railway
Source: S&P's Capital IQ.
You can see that these railroads rely little on asset turnover and have somewhat high leverage. While their asset turnover figures all lie in a similar range, the real differences come in net margin and leverage. Canadian National Railway has the highest returns on equity and by far the highest net margin, even without as much leverage as its peers. CSX uses more leverage to help offset a lower net margin. Norfolk Southern and Union Pacific put up about the same ROE, with similar net margins, though Norfolk Southern uses more leverage.
High fuel prices and an improving economy have benefited companies like Union Pacific as businesses look for cheaper ways to transport their goods than through the trucking industry. These conditions have also helped companies like Norfolk Southern, which has recently reported increases in its coal and automotive shipments, and CSX, which recently reported higher overall freight volume.
CSX and Norfolk Southern have done a better job offering strong dividend growth, but Union Pacific offers a solid 2.1% yield -- somewhat worse than CSX's 2.6% -- and beats out Canadian National Railway's 1.7% yield. Norfolk Southern, however, beats them all with a 2.7% yield.
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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Jim Royal, Ph.D., does not own shares in any company mentioned. Motley Fool newsletter services have recommended buying shares of Canadian National Railway. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.