How Does Big Tobacco Really Make Its Money?

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

By using the DuPont Formula, you can 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 much the company is relying on debt 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 Altria (NYSE: MO) and a few of its sector and industry peers.

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

Reynolds's ROE of 19% doesn't look too shabby -- until you see the ROEs of the other major players in the tobacco industry. Still, Reynolds does earn about half the net margins of its peers, and it runs with less leverage, lowering its return on equity. The other three rivals put up gaudy numbers, with net margins in the 20s and varying levels of leverage. These companies are able to take on increased leverage due to the stable demand for their products, and they don't build up much equity because they consistently pay out their profit in massive dividends.

Breaking down a company's return on equity can often give you some insight into how it's competing against peers and what type of strategy it's using to juice its return on equity.