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 Graco
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
Source: S&P Capital IQ.
Graco's returns on equity are far higher than that of the other companies. Its net margins are more than 5 percentage points higher than any of the others, and it also sports the highest asset turnover and leverage ratio. Flowserve has nearly 20% returns on equity, with the second highest leverage ratio. Gorman-Rupp comes in third but uses the least leverage of the companies and puts up the lowest margins. IDEX has the lowest returns on equity of its industry peers, with an asset turnover far below that of the other companies.
Graco produces equipment that is useful in a variety of industries, including tomato-sauce dispensers used in assembly lines, gadgets used to spray stain onto end tables, and equipment used to apply spray tan. By testing all of its equipment extensively, Graco keeps its warranty costs down -- at less than 1% of total sales. Doing so promotes the company's reputation for high quality, which allows it to charge more for its products.
Graco's high research-and-development budget also increases the likelihood of future innovation that will keep the company relevant and help it maintain a long-term competitive advantage over competitors such as Colfax.
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., owns no shares in any company mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.