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 Duke Energy (NYSE: DUK) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Duke Energy

5.6%

9.1%

0.24

2.60

Exelon (NYSE: EXC)

19.8%

14.3%

0.36

3.80

Southern Company (NYSE: SO)

13.5%

12%

0.33

3.44

American Electric Power (NYSE: AEP)

9.5%

8.9%

0.29

3.63

Source: Capital IQ.

You can see right away how low asset turnover hurts the returns on equity of these utilities. The massive capital requirements of the industry are simply a fact of life here, as is the heavy leverage that these players use. Duke Energy fires up a relatively unimpressive return on equity, and you can see that across all three categories, which lag the metrics of peers. Exelon leads this group, with the highest margins, the best asset turnover, and the most leverage. Southern achieves somewhat lower metrics in each category, and still ends up with a respectable, but much lower, ROE than Exelon. American Electric Power uses high leverage to juice its ROE, since its margins are not relatively attractive.

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., owns shares of Exelon and Southern. Exelon is a Motley Fool Inside Value recommendation. Southern is a Motley Fool Income Investor pick. Motley Fool Options has recommended writing covered calls on Exelon. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.