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 Annaly Capital (NYSE: NLY ) 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
|Chimera Investment (NYSE: CIM )||17.8%||90.4%||0.07||2.71|
|American Capital Agency (Nasdaq: AGNC )||23.9%||92.4%||0.03||9.81|
|Anworth Mortgage Asset (NYSE: ANH )||12.7%||89.9%||0.02||8.17|
Source: S&P Capital IQ.
Annaly Capital offers the lowest ROE of these companies. Its net margins are close to 80%, while its industry peers have net margins clustering around the 90% range. It also has the lowest asset turnover and a leverage ratio that falls near the middle of the pack. American Capital Agency's ROE outperforms its industry peers by several percentage points, with the highest numbers in each category and a particularly high leverage ratio. Chimera has a ROE that competes with the other businesses despite the fact that its leverage ratio is several points below that of the other companies, with the company focusing on higher asset turnover.
Despite its low ROE, Annaly still has several features that make it look appealing. For starters, its 14.2% dividend yield is head and shoulders above what investors will usually find in the market as a whole. However, some of its industry peers also offer high yields, with Chimera coming in at 16.7%, American Capital Agency offering 19.9%, and Anworth 13.4%. However, such high yields should raise worries about whether the companies can sustain the cash flows they need to maintain those payouts.
Part of what has allowed these businesses to succeed is the current low interest rates, which will not be around forever. However, Federal Reserve Chairman Ben Bernanke's claim that he will keep interest rates low into 2013 certainly buys these companies some time to continue their success. But other obstacles may interfere with ongoing profit growth, including financial reform limiting the use of leverage or new government-backed refinancing programs.
While these businesses currently have a great deal to offer, investors would do well to remember the volatility in this sector that can be caused by economic and regulatory changes.
Retirees and other conservative investors have to love the healthy income that Annaly provides, but the stock's recent volatility shows just how sensitive it is to both economic news and threats to its business model. Investors have to be prepared for the impact to earnings and the dividend that narrowing interest-rate spreads will eventually bring, but for now, Annaly is enjoying an unprecedented set of circumstances in the economy that is serving its shareholders very well.
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.
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