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 Western Refining
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
Source: S&P Capital IQ
Western Refining's ROE dwarfs that of the other companies. Much of this can be explained by its leverage ratio, which is much higher than that of the other listed companies. It also has the highest asset turnover, and net margins that come close to Tesoro's
While Western Refining has benefited from an increase in refined oil prices, its revenues suffered from a reduction in throughput volume. Western's biggest refineries, El Paso and Gallup, accounted for a 5% drop in volume. This problem was exacerbated by the fact that Western's expenses of running the refinery did not reduce with the reduction in throughput.
Valero Energy has taken advantage of favorable oil pricing to pay down its debt and purchase new refineries from Chevron
Tesoro has suffered from a relatively flat stock performance while the overall stock market took off after the market meltdown. However, things may improve for the company as unrefined oil becomes cheaper than light sweet crude, which means more business for refineries like Tesoro and Western. It has also allowed the companies to increase the spread between the price they pay for crude oil and the price they charge for gasoline and heating oil.
Copano Energy offers a generous 6.8% dividend yield, which dwarfs Western's 1% yield and Valero Energy's 2.9% yield. Tesoro lacks a dividend altogether.
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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Jim Royal, Ph.D., does not own shares in any company mentioned. The Motley Fool owns shares of Western Refining. Motley Fool newsletter services have recommended buying shares of Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.