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 (Nasdaq: AMZN) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio 22.4% 3.6% 2.66 2.32
eBay (Nasdaq: EBAY) 12.4% 19.7% 0.45 1.39
Costco (Nasdaq: COST) 12.5% 1.7% 3.23 2.30
Target (NYSE: TGT) 18.9% 4.2% 1.47 3.05

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

Amazon offers the highest return on equity among this group, even though its net margins aren't the highest and are even lower than Target's. What really boosts Amazon's returns are its high asset turnover and relatively high leverage. Costco has a similarly high asset turnover and leverage, but its net margins -- half those of Amazon -- cut its ROE to half of Amazon's. Interestingly, Target gets better margins than Amazon and uses high leverage to help boost returns. With its different business model, eBay can achieve much more attractive net margins, but its much lower asset turnover and leverage reduce its ROE to solid, if unspectacular, 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. Costco is a Motley Fool Inside Value choice., Costco, and eBay are Motley Fool Stock Advisor selections. The Fool owns shares of Costco and eBay. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.