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Understanding the F40

How does the modified Dupont Model reward utilities?

Fortnightly Magazine - September 2007

The impact of dividend policies, capital expenditures, and publicly traded equities highlights an in-depth look at what goes into the modified Dupont Model behind the financial rankings for utilities.

The original Dupont Model was developed to address the need for performance metrics, or in today’s terminology, financial benchmarks of an asset-intensive industry, specifically I.e. Dupont’s chemical businesses. Our use of the original 1919 model has been modified to include the impacts of dividend policies, capital expenditures, and publicly traded equities. Even though the original model is pushing 90 years of age, and many newer, more complex models are in use today, the Dupont remains a key tool for the financial assessment of the players in an asset-intensive industry.

While the Dupont is targeted specifically to asset-heavy industries, the model itself is not asset-heavy in its weightings. In fact, profitability measures come close to dominating how a company is ranked. We pulled apart the six formulas that when combined on an equal weighting determine the ranking of a company in the Fortnightly 40 . There are eight key components of the formulas as shown in the left-hand column of Table 1. The profitability measures are a combination of Net Income, Net Income Before Taxes, and Net Income Before Taxes and Depreciation.

Profitability measures are key components of four of the six formulas, representing a 29.17 percent overall weighting. Looking at the top 10 list of companies based on net income as a percent of revenues, averaged over the past three years, it shows significant overlap with the top 10 in this year’s Fortnightly 40 (see Table 2.)

After profitability, revenue weighs in next in the influence on our rankings. Its greatest impact is on the development of the Dupont ROA and a much lesser impact in the calculation of Dupont ROE. In the remaining formulas, revenues are just a reference metric against which profitability is calculated. The model does not contemplate the absolute number or scale of revenues, just revenues as either a numerator or denominator.

Common dividend policies have the third greatest impact on rankings, with a 12.5 percent weighting. Unlike the other metrics used in the formulas, common dividend payout and dividend yield are not rewarded for being bigger. Fig. 1 plots the net income and dividend yield for each company in our analysis. While it is clear that there is a relationship between a company’s three-year average net income margin and its Fortnightly 40 rank, it is also clear that a relatively weak relationship exists between a company’s dividend yield and its Fortnightly 40 rank. A correlation analysis showed a slight relationship.

Like dividend yields, dividend payout ratios almost were neutral in the relationship between yields and rank. While Fig. 3 visually implies a bias toward lower payouts for those companies ranked higher in the Fortnightly 40 , a simple correlation analysis did not find any relationship. Given the angst spent on dividend policies in this industry in particular, the