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 Frontier Communications (NYS: FTR) 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?
Windstream (NAS: WIN)
CenturyLink (NYS: CTL)
AT&T (NYS: T)
Source: S&P Capital IQ.
Frontier Communications offers the lowest ROE of its industry peers, at just above 3%. Its net margins are far below that offered by the other listed companies, and its asset turnover, while comparable to its peers, still comes in last. Its leverage ratio, on the other hand, is the second highest. Meanwhile, Windstream runs on a sliver of equity, and thus its very high leverage ratio is what helps to boost ROE.
Frontier, CenturyLink, and Windstream are all suffering similarly from the lack of growth in the rural markets that they serve. Nevertheless, they still pump out some serious cash from their businesses, and that ability allows them to provide attractive dividends (Frontier yields 13.5%).
However, Frontier's acquisition of some Verizon (NYS: VZ) assets last year offers some hope that the company will be able to improve its ROE because it gives it the company a chance to take advantage of economies of scale, and so improve net margins. Also, the company saw an increase in its returns on invested capital from last year, which is a good sign for a future increase in its ROE.
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 Jim Royal, Ph.D.,does not own shares in any company mentioned.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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