How Do These Retailers Really Earn Their Cash?

As investors, we need to understand how our companies truly make their money. Thankfully, there's a neat trick developed for just that purpose: the DuPont formula.

The DuPont formula can help you get a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company that pioneered it, the DuPont formula breaks down return on equity into three components:

Return on equity = Net margins x asset turnover x leverage ratio

High net margins show that a company is able to get customers to pay more for its products. (Think luxury-goods companies.) High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. (Think service industries, which often lack high capital investments.) Finally, the leverage ratio shows how heavily the company relies on liabilities to create profit.

Generally, the higher these numbers, the better. But too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's take a look at Staples (Nasdaq: SPLS) and a few of its sector and industry peers.

Source: Capital IQ, a division of Standard & Poor's.

It's impressive that Bed Bath & Beyond is able to earn nearly 9% margins in the retail sector. It was able to turn that into an impressive ROE without resorting to too much leverage. Staples has had much smaller margins, more in line with typical retailers, as does Macy's. Macy's uses its much higher leverage ratio to offset lower asset turnover and thin margins. Sears earned an unimpressive ROE over the past four quarters, largely attributable to razor-thin margins, since leverage and asset turnover fall within the range of peers.

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.