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. But 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 Eastman Kodak (NYSE: EK) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Eastman Kodak

NM

(16.0%)

1.01

NM
Canon (NYSE: CAJ)

8.8%

6.5%

1.01

1.40
Sony (NYSE: SNE)

(7.1%)

(3.6%)

0.59

4.15
Lexmark International (NYSE: LXK)

25.1%

7.8%

1.16

2.76

Source: Capital IQ, a division of Standard & Poor's. NM = not meaningful.

Eastman Kodak's return on equity is not meaningful, because of negative equity. But even if equity were positive, the company still reported a loss over the last four quarters, so ROE would have been negative anyway. Lexmark leads this pack, with the best margin, the highest asset turnover, and somewhat high leverage. Canon's numbers fall somewhat lower, but the leverage is only about half that of Lexmark, hurting overall ROE. While Sony uses the highest leverage of these peers, its asset turnover is also the lowest, and a negative net margin drags ROE into the red.

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. And if you'd like to, add these companies to your watchlist.