How Do These High-Yielding REITs Really Make Their Money?

As investors, we need to understand how our companies truly make their money. And there's a neat trick developed for just that purpose. It's called the DuPont Formula.

By using the DuPont Formula, you can get 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 DuPont Formula breaks down return on equity into three components:

Return on equity = Net margins x asset turnover x leverage ratio

High net margins show that a company is able to get customers to pay more for its products. (Think luxury goods companies.) High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. (Think service industries, which often do not have high capital investments.) Finally, the leverage ratio shows how much the company is relying on debt to create profit.

Generally, the higher these numbers, the better. Of course, too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's take a look at Annaly Capital Management (NYSE: NLY  ) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Annaly Capital Management 8.2% 79.7% 0.01 8.03
Chimera Investment (NYSE: CIM  ) 18.5% 91.6% 0.09 2.28
American Capital Agency (Nasdaq: AGNC  ) 28.4% 92.1% 0.03 10.46
Anworth Mortgage Asset (NYSE: ANH  ) 12.7% 88.2% 0.02 6.95

Source: Capital IQ, a division of Standard & Poor's.

Each of these companies offers a truly amazing dividend, ranging from 12.7% for Anworth to 19% for American Capital Agency. And how do these guys do it? This DuPont formula screen shows clearly: high leverage and fat net margins. Net margins for these group ranges from 80% to 92%, while most are very highly leveraged, with the exception of Chimera. Those tasty dividends bring out the gambler in some investors, which may explain why you might want to avoid some of these too-tempting stocks.

Breaking down a company's return on equity can often give you some insight into how it's competing against peers and what type of strategy it's using to juice its return on equity.

Jim Royal, Ph.D., owns shares of Annaly. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 18, 2011, at 11:36 AM, anuragupta wrote:

    This article does not explain how their REITs make money. It only demonstrates the formula for ROE.

    This article does not comment on which of the listed REITS offers the most reward to risk ratio, which has the least risk etc. to help an investor.

    I struggle to understand what use is this article to anyone?

  • Report this Comment On January 18, 2011, at 11:48 AM, HighYieldAnalyst wrote:

    anuragupta ... I am with you on this poorly constructed "article" ... unfortunately, this is a widely used tactic ... using an article title that sounds interesting or inflamatory will get clicks and this is where fool.com makes income ... from clicks on their links or to sell subscriptions to their publications.

    I think it is detrimental strategy in the long term since I am less likely to click on a fool.com article.

  • Report this Comment On January 18, 2011, at 11:55 AM, pondee619 wrote:

    "Generally, the higher these numbers, the better. Of course, too much debt can sink a company, so beware of companies with very high leverage ratios."

    So, CIM is best of this group? Second highest return on equity, Second highest net margin, Highest asset turnover and Lowest leverage ration.

  • Report this Comment On January 18, 2011, at 1:47 PM, jb97127 wrote:

    Excuse me. I am only a G.E.D. graduate but it seems to me the more money you can borrow from the FEDS at 1% to loan out or buy securities backed by the FEDS that bring in "NET" more than 1% is not only good business but a smart way to go. I own CIM,ANGC,ANH,..Untill FEDS raise Rate I am not worried.

    Putz

  • Report this Comment On January 18, 2011, at 7:23 PM, worthless111 wrote:

    Putz, Thanks for the message. This is exactly how I feel having fled the Canadian energy trusts and searched for a new source of income. As they say, " True this " !

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