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 neutrality of the Dupont Model to dividends is a somewhat surprising finding.

Share price is contemplated only in the model as it relates to dividend yield. Changing share price will affect dividend yield, since the model uses the formula annual dividends per share divided by year-end share price. However, market capitalization is not a considered factor.

Cash-flow statement metrics are captured through the use of both operating income and capital expenditures. Combined, these two metrics create free cash flow and are given significant weighting in the model, at 16.67 percent. Not surprising, companies are rewarded by the model for having positive free cash flow. The implication is that the model is punitive to companies with significant capital-expenditure requirements.

Balance-sheet impacts are captured through the use of total shareholder equity and total assets. However, shareholder equity is the least weighted of all factors in our analysis at 2.5 percent.

Total company assets are used in calculating three of the six key formulas: Sustainability, Dupont ROA, and Dupont ROE. In the Dupont ROA calculation, assets represent 25 percent of the formula. In the Dupont ROE calculation, assets represent less than 20 percent of the calculation. Overall, assets rank fourth in the impact on the Fortnightly 40 rankings, with a weighting of 9.17 percent.

So while the hybrid Dupont Model is very much tailored to asset-intensive industries such as energy utilities, it is not just a simplistic measure of asset efficiency. It captures key metrics from the income statement, cash-flow statement, and balance sheet, as well as the impact of the company’s common equity on its dividend policies. And it focuses on the fundamental aspect of all businesses, the creation of real profits.