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 it can tell us about Frontier Communications
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.
Thin margins, low asset turnovers, and high leverage -- that's what these players have in common. Windstream has by far the highest return on equity of these companies. While its net margins and asset turnover are comparable with that of the other companies, its leverage ratio is more than triple that of the next highest. So leverage is the real driver of higher ROE there. CenturyLink and AT&T both have 3.8% returns on equity. AT&T's asset turnover is higher than CenturyLink's, but the latter's numbers are higher in the other two areas. Frontier has the lowest ROE of these companies, largely because of its low margin and asset turnover.
Frontier Communications has both a landline business and a broadband-services business. Its landline business is suffering because of consumers' increasing reliance on cell phones, though it has taken on some of Verizon's legacy landline customers. Frontier has also managed to grow its broadband-services business and recently struck a three-year deal with AT&T to resell wireless services.
Although telecom is known for its big dividends, Frontier recently slashed its quarterly payout from $0.1875 per share to $0.10. And the company is predicting a free cash flow decline for 2012.
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., owns shares in AT&T and Frontier. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.