How Does PACCAR Really Juice Its Return on Equity?
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.
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.
Let's see what the DuPont formula can tell us about PACCAR (NAS: PCAR) and a few of its sector and industry peers:
Return on Equity
Danaher (NYS: DHR)
Lear (NYS: LEA)
Visteon (NYS: VC)
Source: Capital IQ, a division of Standard & Poor's.
PACCAR and its peers achieve decent to very good returns on equity, but they rely on different levers to get the job done. PACCAR achieves a middling net margin and uses a fair bit of leverage to boost its ROE. Danaher can achieve much higher margin but lower asset turnover and less leverage make its ROE look comparable to PACCAR's. Lear uses high asset turnover and leverage to boost ROE, even with a mediocre margin. Visteon takes the award for gaudiest return on equity, with a strong net margin, solid asset turnover, and very high leverage.
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. If you'd like to add these companies to your watchlist, click on any of the links below:
- Add Visteon to My Watchlist.
- Add PACCAR to My Watchlist.
- Add Lear to My Watchlist.
- Add Danaher to My Watchlist.
At the time this article was published Jim Royal, Ph.D.,does not own shares in any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of PACCAR. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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