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 Capstead Mortgage (NYS: CMO) 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?
Invesco Mortgage Capital (NYS: IVR)
CYS Investments (NYS: CYS)
Hatteras Financial (NYS: HTS)
Source: S&P Capital IQ
Capstead Mortgage has the lowest returns on equity of the listed companies, despite the fact that it has the highest leverage ratio out of them. CYS's returns on equity are eight percentage points higher than its listed industry peers, which can largely be attributed to its very high net margins, which are more than 26 percentage points higher than the company coming in second place in that category. That margin is mostly due to non-recurring accounting treatments.
As real estate investment trusts, or REITs, these companies can gain tax-favored status by paying out 90% of their net income to investors. That, combined with low interest rates and high leverage ratios, allow Annaly Capital (NYS: NLY) , Chimera Investment, American Capital Agency, and the four companies listed above to top the dividend yield listings in the general marketplace.
Federal Reserve Chairman Ben Bernanke claims that the current low interest rates, which allow these companies to maintain their cash flows, will continue into 2013, promoting their short-term success. However, potential financial reforms may limit the use of leverage. The Securities and Exchange Commission, or SEC, has considered the possibility of regulating mortgage REITs like mutual funds, which would dramatically limit the return on equity these companies can achieve.
Capstead Mortgage has a 13.7% dividend yield, but it also has one of the highest leverage ratios seen, even among mortgage REITs. If the SEC decides to start regulating mortgage REITs like mutual funds, this could affect Capstead Mortgage even more than it affects its industry peers.
The yields on other companies are just as impressive. CYS Investments specializes in single-family residential mortgage-backed securities that are guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, and offers a 15.3% dividend yield. Invesco offers a whopping 18.6% dividend yield. Hatteras offers a 13.7% dividend yield. While Hatteras has been able to grow its earnings per share substantially since its 2007 launch, its ability to maintain that pattern may be disrupted with rising interest rates and financial reform.
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.
While the dividends offered by mortgage REITs are high, they don't necessarily offer investors the stable income they're looking for. If you'd like to learn more about how you can get more predictable dividend payments at attractive yields, check out our free report, "Secure Your Future With 11 Rock-Solid Dividend Stocks." It's available free for a limited time. Just click here to get your copy.
At the time thisarticle was published Jim Royal, Ph.D.,owns shares in Annaly Capital Management.The Motley Fool owns shares of Annaly Capital Management.Motley Fool newsletter serviceshave recommended buying shares of Annaly Capital Management. 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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