How Do These Retailers 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 Home Depot (NYSE: HD) and a few of its sector and industry peers.

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

The margins of these companies are pretty comparable, all in all. Home Depot bests its closest rival, Lowe's, in return on equity by bagging bigger margins and operating with more leverage and higher asset turnover. Lumber Liquidators scores a higher ROE than either of these heavyweights by doubling its asset turnover, and does it with the lowest leverage ratio here. Tractor Supply tops this ROE list, by focusing on high asset turnover and a medium level of leverage, for these companies.

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.