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 McDonald's (NYSE: MCD) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio






Yum! Brands (NYSE: YUM)





Chipotle Mexican Grill (NYSE: CMG)





Darden Restaurants (NYSE: DRI)





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

McDonald's clearly differentiates itself from the competition by its net margins, which are double that of its other fast-food competitors. Its focus on refranchising operations has helped it drive high margins, which in turn has led to a solid return on equity. Yum! uses more leverage to juice its gaudy return on equity, while Chipotle funds its operations from cash flow, resulting in a lower ROE, even though both have similar net margins. Darden -- the name behind Olive Garden and Red Lobster, among others -- relies less on margins than on leverage and asset turnover to achieve a nice ROE.

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. Chipotle is a Motley Fool Rule Breakers selection. Chipotle is a Motley Fool Hidden Gems pick. The Fool owns shares of Chipotle and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.