How Do These Energy Companies Boost Their Returns?

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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 Western Refining (NYS: WNR) 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?

Western Refining24.3%2.2%3.053.64
Copano Energy(14.9%)(12.6%)0.631.88
Tesoro18.7%2.4%3.032.50
Valero Energy13.9%1.4%2.852.46

Source: S&P Capital IQ

Western Refining's ROE dwarfs that of the other companies. Much of this can be explained by its leverage ratio, which is much higher than that of the other listed companies. It also has the highest asset turnover, and net margins that come close to Tesoro's (NYS: TSO) , which throws out the top numbers in that category. Copano (NAS: CPNO) has negative ROE, which results from its negative net margins. Valero's (NYS: VLO) leverage ratio is close to Tesoro's but its net margins are well below Western's and Tesoro's .

While Western Refining has benefited from an increase in refined oil prices, its revenues suffered from a reduction in throughput volume. Western's biggest refineries, El Paso and Gallup, accounted for a 5% drop in volume. This problem was exacerbated by the fact that Western's expenses of running the refinery did not reduce with the reduction in throughput.

Valero Energy has taken advantage of favorable oil pricing to pay down its debt and purchase new refineries from Chevron (NYS: CVX) and Murphy Oil.

Tesoro has suffered from a relatively flat stock performance while the overall stock market took off after the market meltdown. However, things may improve for the company as unrefined oil becomes cheaper than light sweet crude, which means more business for refineries like Tesoro and Western. It has also allowed the companies to increase the spread between the price they pay for crude oil and the price they charge for gasoline and heating oil.

Copano Energy offers a generous 6.8% dividend yield, which dwarfs Western's 1% yield and Valero Energy's 2.9% yield. Tesoro lacks a dividend altogether.

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, or set up a new one, just click below:

At the time this article was published Jim Royal, Ph.D.,does not own shares in any company mentioned.The Motley Fool owns shares of Western Refining.Motley Fool newsletter serviceshave recommended buying shares of Chevron. 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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