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 UPS (NYSE: UPS ) 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
|United Parcel Service||50.1%||7.8%||1.54||4.16|
|FedEx (NYSE: FDX )||11.5%||4.2%||1.52||1.79|
|Expeditors International of Washington (Nasdaq: EXPD )||21.1%||6.2%||2.23||1.51|
Source: S&P Capital IQ.
*Because YRC has negative average equity, its ROE is not meaningful.
UPS's returns on equity are more than double what the other companies here offer. It does so largely through its leverage ratio, which dwarfs that of its listed peers. It also has higher net margins than the other companies, more than enough to make up for its relatively low asset turnover. Expeditors International falls in second, with returns on equity above 20%, largely achieved by an asset turnover significantly higher than its peers, and relatively high net margins. Aside from YRC Worldwide, FedEx has the lowest ROE, net margins, and asset turnover.
While UPS has shown some reasonable growth in the past year (above 8%), its five-year average growth rate is below 3%. Its dividend growth has also been moderate, with a five-year average growth rate of less than 7%. However, its current yield is a reasonable 2.8%, which stands up well against FedEx's 0.8% yield, Expeditors' 1.2% yield, and YRCW's lack of dividend.
One future obstacle for UPS is the long-term trend of rising fuel costs, which will also affect competitors like J.B. Hunt Transport, YRC, and its aforementioned peers. However, higher fuel prices could help UPS gain a competitive advantage from its use of intermodal shipments, which reduce its reliance on fuel while they help railroad businesses CSX and Norfolk Southern increase their revenues.
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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