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 PG&E (NYS: PCG) 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?
Edison International (NYS: EIX)
Sempra Energy (NYS: SRE)
Exelon (NYS: EXC)
Source: S&P Capital IQ
PG&E's return on equity is the second lowest of the listed companies. However, its asset turnover and leverage ratio are comparable to those offered by its industry peers. It ties with Sempra Energy for offering the second highest asset turnover and ties with Edison International for offering the highest leverage ratio.
One thing that makes PG&E attractive is that it does not simply offer the standard services associated with utility companies -- it is also attempting to innovate and find new ways to generate power. For example, the company is experimenting with using solar and wind energy to fill compressed air tanks that can be used to produce electricity when it is needed. This experiment, if successful, could give the company an edge against its competitors.
PG&E has also offered steady revenue growth and, along with Exelon, it offers a higher dividend yield (4.8%) than Edison International (3.3%) and Sempra Energy (3.6%). The stable earnings coming from these dividends, along with the potential growth opportunities coming from renewable energy innovations, make PG&E an attractive low-risk stock with some growth potential.
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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At the time thisarticle was published We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.Jim Royal, Ph.D.,owns shares of Exelon.Motley Fool newsletter serviceshave recommended buying shares of Exelon.Motley Fool newsletter serviceshave recommended creating a write covered strangle position in Exelon. 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.