As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont Formula -- can help us do so.

The DuPont Formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:

Return on equity = net margins x asset turnover x leverage ratio

What makes each of these components important?

  • High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
  • High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
  • Finally, the leverage ratio shows how much the company is relying on debt to create its profits.

Generally, the higher these numbers, the better. That said, too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's see what the DuPont Formula can tell us about Occidental Petroleum (NYSE: OXY) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Eni (NYSE: E)

12.9%

6.6%

0.80

2.37
Occidental Petroleum

14.2%

22.4%

0.42

1.49
Suncor Energy (NYSE: SU)

5.2%

8.3%

0.48

1.99
Marathon Oil (NYSE: MRO)

9.1%

3.5%

1.36

2.06

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

Occidental has the best trailing margins of this group, but its ROE just edges Eni's because it runs with less leverage and much less asset turnover. Marathon and Suncor both run at single-digit ROEs. Despite lower margins, Marathon's higher asset turnover and decent leverage boost ROE substantially. Suncor's lower asset turnover also pulls down its ROE, even though margins are second among these peers.

Using the DuPont formula can often give you some insight into how a company is competing against its peers and what type of strategy it's using to juice return on equity.

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