How Do These Telecoms Really Make Their Money?

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

By using the DuPont formula, you can 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 where it was pioneered, 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 do not have high capital investments. Finally, the leverage ratio shows how much the company is relying on debt to create profit.

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

Let's take a look at Frontier Communications (NYSE: FTR) and a few of its sector and industry peers.

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

The ROEs here are all over the place. Frontier's low margins in the last four quarters hurt its ROE and it has the lowest asset turnover of this bunch, while its leverage ratio is higher than CenturyLink and MetroPCS. Windstream's gaudy ROE is due in large part to the sliver of equity it has. CenturyLink and MetroPCS turn in about the same ROE, but get there by much different routes. CenturyLink goes with higher margins, while its rival has higher asset turnover and leverage ratios.

Breaking down a company's return on equity can often give you some insight into how it's competing against peers and what type of strategy it's using to juice its return on equity.