How Do These Telecoms Really Earn Their Cash?

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

The DuPont formula can help you 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 that pioneered it, 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 lack high capital investments.) Finally, the leverage ratio shows how heavily the company relies on liabilities to create profit.

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

Let's take a look at China Mobile (NYSE: CHL  ) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

China Mobile

23.3%

25.0%

0.60

1.54

Telefonica (NYSE: TEF  )

56.7%

18.6%

0.52

5.91

France Telecom (NYSE: FTE  )

10.0%

9.1%

0.49

3.18

Nippon Telegraph & Telephone (NYSE: NTT  )

6.8%

5.2%

0.55

2.40

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

The asset turnovers of these telecoms are all in a narrow range, so the key differentiators will be leverage ratio and margins. China Mobile looks like the real star here, even though its ROE is well below that of Telefonica. China Mobile relies on its fat margins and doesn't use a high leverage ratio to boost ROE. In contrast, Telefonica uses a high leverage ratio to greatly magnify its healthy margins. France Telecom and Nippon Telegraph achieve less gaudy numbers, with lower margins and less, though still substantial, leverage.

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.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Jim Royal, Ph.D., does not own shares of any of the companies mentioned. China Mobile is a Motley Fool Global Gains pick. France Telecom is a Motley Fool Income Investor recommendation. The Fool owns shares of China Mobile and Telefonica. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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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 30, 2011, at 4:27 PM, MFJPMARTIN wrote:

    Interesting enough i was doing an analysis of the same: just by looking at the ratios... feel free to correct my workings if you find any errors.

    See it at http://jpm.io/ttt

    $CHL, $FTE, $VZ, $DCM (NTTDocomo)

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