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 Fastenal (Nasdaq: FAST ) 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
|W.W. Grainger (NYSE: GWW )
|MSC Industrial Direct (NYSE: MSM )
|WESCO International (NYSE: WCC )
Source: S&P Capital IQ.
W.W. Grainger offers the highest returns on equity of these companies, with Fastenal not far behind. W.W. Grainger largely achieves its high ROE with an asset turnover and leverage ratio that is fairly high compared with its industry peers. Its net margins, on the other hand, are the second lowest of this group. While Fastenal has higher net margins than its listed peers, it has a lower asset turnover and leverage ratio.
MSC also offers returns on equity in the 20% range, with the second highest net margins, but the second lowest asset turnover and leverage ratio. WESCO International has the lowest ROE despite having the highest asset turnover and leverage ratio, which is largely due to very low net margins compared with its industry peers.
Fastenal offers a fairly modest dividend yield at 1.2%. But that is comparable with the yield offered by some of its peers, with W.W. Grainger and MSC Direct offering 1.4% yields, and WESCO International failing to offer a dividend at all. In addition, Fastenal's five-year average growth rate in its dividend payout is an appealing 20.6%, and it has a strong track record for increasing its dividend, with increases 12 years in a row. Its 44.8% payout ratio gives it room to continue to increase its dividend in the future.
It is also worth noting that Fastenal has continued to perform well despite a recession that has hit the construction business hard. During this time, it has continued to expand its business. It has also benefited from partnerships with Kimberly-Clark, 3M, and Eaton, which has given it an advantage in keeping up its sales.
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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