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.

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.

Let's see what the DuPont Formula can tell us about Packaging Corp. of America (NYSE: PKG) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Packaging Corp. of America

23.2%

8.9%

1.15

2.28

International Paper (NYSE: IP)

16.4%

4.5%

1.02

3.72

Rock-Tenn (NYSE: RKT)

22.7%

7.1%

1.09

2.84

Domtar (NYSE: UFS)

22.5%

11.7%

0.92

2.10

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

The returns on equity here are all good, even as the margins are solid but not spectacular. With asset turnover in a fairly narrow range, differences in ROE are due largely to leverage and margins. Packaging Corp., Rock-Tenn, and Domtar all have similar returns on equity, with Domtar scoring higher margins and Rock-Tenn using more leverage to boost ROE. International Paper uses significantly higher leverage to help offset a lower net margin in order to achieve a mid-teens ROE.

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. If you'd like to add these companies to your watchlist, or set up a new one, just click here .