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.

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.