How Does Capstone Turbine Boost Its 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 Capstone Turbine (Nasdaq: CPST) 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?

Source: S&P Capital IQ.
*Because NAV has negative average equity, its ROE is not meaningful.

Capstone Turbine's negative returns on equity are explained by its negative net margins. Cummins has the highest ROE of these companies. While its leverage ratios are comparable to that of its industry peers, its asset turnover is the highest and its net margins are the second highest. Briggs & Stratton has the highest leverage ratio of the companies, and a comparable asset turnover, but its net margins are quite low.

Capstone Turbine produces microturbines that can generate electricity off the power grid to serve customers who collect oil and other natural resources in remote locations that lack traditional access to power. Last year marks the first point at which Capstone has made a profit, which could be a turning point for the company. Capstone is also generating additional investor interest through its new focus on alternative energy. However, Capstone lacks the cash to even support a modest dividend, while some of its competitors do. For example, Cummins offers a 1.7% yield and Briggs & Stratton offers a 2.7% yield.

Cummins' 30.4% five-year average dividend yield increase and its six-year streak of growing payouts establishes a nice track record, and the fact that its payout ratio is only 13.8% means that the company has room to continue to grow its dividend in the future. Also, Cummins' business model differs from businesses like Navistar and Caterpillar in that it sells its engines to Ford and PACCAR instead of building full vehicles. It has also partnered with Westport Innovations (Nasdaq: WPRT) to produce natural-gas-powered engines that are viable for commercial purchases. This has allowed Cummins to compete effectively and benefit from emerging markets growing at a particularly fast rate.

Briggs & Stratton produces air-cooled gas-powered engines used in outdoor power equipment and sells them to other equipment manufacturers inside and outside of the U.S. In 2011, the company bounced back and forth between failing to meet estimates and beating them. In the most recent quarter, Briggs & Stratton reported overall losses and a lack of revenue growth.

While Navistar lacks a dividend, it has grown its revenues by 28% since last year because of increased demand from Latin America and defense companies. Growth in the latter area is particularly encouraging in the current economic climate, which is raising worries about budget cuts in defense spending. This year, Navistar is planning to extend its involvement in emerging markets by marketing to Brazil and India.

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.

While modest and growing dividends are nice, you may want to increase your dividend yield by investing in companies with strong track records for large and growing payouts. If you'd like to explore more dividend investment opportunities, check out our free report, Secure Your Future With 11 Rock-Solid Dividend Stocks. It's available free for a limited time. Get your copy.