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 margins 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 debt to create its profits.

Generally, the higher these numbers, the better. That said, 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 Unilever (NYSE: UL) and a few of its sector and industry peers:

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Unilever 33.4% 9.6% 1.09 3.19
Kraft Foods (NYSE: KFT) 9.3% 9.0% 0.59 2.67
Kimberly-Clark (NYSE: KMB) 34.0% 9.4% 1.03 3.51
General Mills (NYSE: GIS) 27.8% 11.0% 0.81 3.15

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

Unilever sits right at the top of this group by focusing equally on each of these categories. Net margins and leverage are in the middle of the range here, while asset turnover leads this group. Kraft stands out for its lower ROE, but margins are mostly in line with those of peers. However, asset turnover is much lower while leverage is somewhat lower. Kimberly-Clark and General Mills also strive for fat net margins and comparable levels of leverage to achieve very attractive returns on equity.

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.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Jim Royal, Ph.D., does not own shares of any of the companies mentioned. Unilever is a Motley Fool Global Gains pick. Kimberly-Clark and Unilever are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.