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 Nike (NYSE: NKE) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Nike

21.2%

10.3%

1.43

1.45

lululemon athletica (Nasdaq: LULU)

37.1%

15.2%

1.88

1.29

Under Armour (NYSE: UA)

14.5%

6.2%

1.70

1.38

Polo Ralph Lauren (NYSE: RL)

17.9%

10.5%

1.11

1.53

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

Nike might be the big dog of apparel companies, but lululemon is certainly outclassing it here. Lululemon turns higher margins and better asset turnover into an ROE that is almost twice as great as Nike's, despite less leverage. Under Armour and Polo are no slouches either, with mid- to high-teens returns on equity. Under Armour's efficiently using its assets to generate sales, but its net margins really hurt its ROE. Polo achieves Nike-size margins, but lower asset turnover puts it behind the Swoosh. Interestingly, none of these companies is particularly egregious at using leverage to juice 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 company mentioned here. Lululemon athletica and Under Armour are Motley Fool Rule Breakers recommendations. Nike is a Motley Fool Stock Advisor pick. Under Armour is a Motley Fool Hidden Gems choice. The Fool owns shares of lululemon athletica and Under Armour. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.