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.
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.
Let's see what the DuPont Formula can tell us about Annaly Capital
|
Company |
Return on Equity |
Net Margin |
Asset Turnover |
Leverage Ratio |
|---|---|---|---|---|
|
Annaly Capital |
15.0% |
88.4% |
0.02 |
7.59 |
|
Chimera Investment |
19.6% |
91.4% |
0.08 |
2.81 |
|
American Capital Agency |
18.6% |
93.2% |
0.02 |
8.82 |
|
Anworth Mortgage Asset |
11.4% |
89.0% |
0.02 |
7.79 |
Source: Capital IQ, a division of Standard & Poor's.
The appeal of these mortgage real estate investment trusts is their prodigious dividends. So what's their special sauce? Largely, it's leverage. The net margins all fall in a narrow band, as does the range of asset turnover, with the exception of Chimera, at four times its peers'. Chimera's higher asset turnover offsets its lower leverage, but it still has the best ROE of this group. You can see the leverage ratios of these players are tremendously high, reflecting their business model of borrowing short-term funds to buy long-term mortgages. And that's how they generate their fat dividends.
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. If you'd like to add these companies to your watchlist, or set up a new one, just click here .
