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 Whole Foods Market (Nasdaq: WFMI) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Whole Foods Market





Kroger (NYSE: KR)





Supervalu (NYSE: SVU)





Safeway (NYSE: SWY)





Source: Capital IQ.

Whole Foods doesn't score the best ROE despite its good net margins (for a grocer). While its asset turnover is in line with those of some of its peers, its leverage ratio is much lower, meaning it could boost ROE with more debt.

But the perilous state of some other leveraged grocers makes that look like a less attractive option. Kroger earns nearly double Whole Foods' return on equity, despite margins that are half as good. High asset turnover leverage are responsible. But for SUPERVALU and Safeway, leverage cuts the other way, magnifying their losses. While asset turnover for both looks all right, it's the negative net margins that both companies need to remedy. And SUPERVALU is also working on its debt levels.

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. Whole Foods Market is a Motley Fool Stock Advisor selection. The Fool owns shares of SUPERVALU. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.