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 Johnson & Johnson (NYSE: JNJ) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Johnson & Johnson 25.3% 21.8% 0.66 1.76
Alcon (NYSE: ACL) 35.4% 30.3% 0.80 1.45
Eli Lilly (NYSE: LLY) 43.2% 21.1% 0.80 2.56
Medtronic (NYSE: MDT) 22.4% 20.2% 0.59 1.88

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

Each of these companies has a 20%+ margin, something that makes health care particularly attractive, and makes earning a high return on equity much easier.  Johnson & Johnson and Medtronic earn similar ROEs, but slightly higher asset turnover and margins give J&J the edge. Alcon boasts substantially better margins, which is the key driver for its return on equity. And Eli Lilly, while having similar net margins to Johnson & Johnson, really juices its ROE with substantially higher leverage.

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.

Johnson & Johnson is a Motley Fool Inside Value selection and a Motley Fool Income Investor selection. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Johnson & Johnson, and Medtronic. Motley Fool Alpha owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days.

Jim Royal, Ph.D., owns shares of Johnson & Johnson. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.