How Do These Beverage Companies Really Make Their 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 where it was pioneered, 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 do not have 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. Of course, too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's take a look at Coca-Cola (NYSE: KO) and a few of its sector and industry peers.

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

Coca-Cola's return on equity is a huge testament to its ability to earn fat margins, since its asset turnover is the lowest of this bunch and its leverage ratio is well below that of the other big players. In contrast, PepsiCo has a greater ROE -- driven by higher asset turnover and more leverage. Dr Pepper Snapple relies on a higher leverage to help propel ROE, since its margins are the lowest here. The up-and-coming Hansen sports a high return on equity using nice margins, relatively high asset turnover, and low leverage.

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.