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 Formula do the work. Let's see what the formula can tell us about Exelon (NYSE: EXC ) 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
|Duke Energy (NYSE: DUK )||7.5%||11.7%||0.24||2.67|
|American Electric Power (NYSE: AEP )||10.6%||9.9%||0.29||3.62|
|National Grid (NYSE: NGG )||28.8%||15.4%||0.31||6.07|
Source: S&P Capital IQ.
National Grid has by far the highest returns on equity of these companies, and you can see the key differences. While its asset turnover is close to that of the other companies, it has the highest net margins, and its leverage ratio is by far larger than the others'. Exelon has the next highest ROE, with the highest asset turnover and the second highest net margins and leverage ratio. American Electric Power has returns on equity that are more than 7 percentage points lower than Exelon's, largely because of a much lower margin. Duke Energy's returns on equity are the lowest, largely because of low asset turnover and leverage.
Exelon has managed to keep its share prices relatively steady during the economic crisis. The company's focus on nuclear energy in electricity generation has put it in a strong position to benefit from the government's attempt to find alternatives to fossil-fuel energy. While the earthquake in Japan has raised concerns about nuclear power, nuclear still generates 20% of power in the U.S., and until we find better alternatives it is unlikely that nuclear energy will be abandoned.
Nevertheless, the concerns about nuclear energy have affected several companies with a stake in nuclear power. NRG (NYSE: NRG ) , for example, has written off its investment in its South Texas Nuclear development project, which cost the company nearly $500 million. Uranium miners Cameco and Uranium Energy have also seen their share prices fall.
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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