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

The DuPont Formula can help you 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 heavily the company relies 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 BHP Billiton (NYSE: BHP) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

BHP Billiton










Rio Tinto (NYSE: RIO)





Freeport-McMoRan (NYSE: FCX)





Source: Capital IQ.

These megaminers rely heavily on high net margins to drive return on equity, with some using a higher leverage ratio to boost ROE even further. Freeport-McMoRan, for instance, has the highest return on equity here, but its margins aren't as high as those of some competitors. It uses a higher leverage ratio, as Rio Tinto similarly does, to boost ROE above its higher-margin peers. Vale achieves much better margins than BHP, but its lower asset turnover results in a lower overall return 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. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.