How Do These Utilities Boost Their Returns?
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 Dominion Resources (NYS: D) 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?
Return on Equity
Source: S&P's Capital IQ
Entergy (NYS: ETR) has the highest returns on equity of the listed companies, with the highest net margins and leverage ratio of its competitors. NextEra (NYS: NEE) comes second, with a margin among the top of these companies, though it has the lowest asset turnover. Dominion comes next, with the second highest asset turnover of its listed competitors, and the third highest net margins and the lowest leverage ratio. FirstEnergy (NYS: FE) has the lowest ROE. While it has the highest asset turnover, its net margin is well below that of the other listed companies.
Dominion Resources serves residential properties, businesses, and governmental properties in several Eastern U.S. states with natural gas and electricity. While its increased involvement in the regulated utility business undermines some growth opportunities, it offers the benefit of providing more stable profits in the future.
FirstEnergy generates, transmits, and distributes electricity to customers in Ohio and several nearby states. Its recent merger with Allegheny Energy has the potential to help the company cut costs and improve its financial performance. It has also, with some success, used competitive pricing to steal businesses from competitors like American Electric Power, Duke Energy, and Exelon.
Entergy is increasing its focus on its core power utility business by spinning off its transmission business and merging it to ITC Holdings. This will allow Entergy to focus its funds on growing its core business by strengthening its generating and distribution capacities. It will also be able to use the funds from the ITC deal to pay off its debt.
And of course, these utilities are dividend powerhouses. NextEra Energy offers a 3.7% yield, but that yield is topped by Dominion Resources' 3.9% yield, First Energy's 5.2% yield, and Entergy's 4.7% yield.
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At the time this article was published Jim Royal, Ph.D.,owns shares of Dominion, Duke, and Exelon. The Motley Fool owns shares of NextEra Energy. The Fool has written puts on NextEra Energy.Motley Fool newsletter serviceshave recommended buying shares of ITC Holdings, Dominion Resources, and 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.
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