How Do These Oil 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 Exxon-Mobil (NYSE: XOM) and a few of its sector and industry peers.

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

ExxonMobil scores the highest ROE among these major oil players, by focusing on asset turnover and leverage that are near the top of the ranks. While Chevron scores higher net margins, its asset turnover and lower leverage put it behind Exxon's ROE. Royal Dutch Shell's lower return on equity is due largely to its lower net margins, which are half that of the other players. PetroChina has the lowest asset turnover and leverage of this group, which mitigate its relatively high net margin, putting its ROE in the middle of this pack.

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.