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 liabilities 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 Nokia (NYSE: NOK) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Nokia

16.0%

4.9%

1.11

2.84
Research In Motion (Nasdaq: RIMM)

43.0%

17.3%

1.69

1.47
Garmin (Nasdaq: GRMN)

27.0%

25.1%

0.81

1.33
Motorola Mobility Holdings (NYSE: MMI)

-21.9%

-3.4%

1.63

3.96

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

Nokia achieves a solid return on equity, but high net margins aren't really part of the story here. The company's reliance on a high leverage ratio really juices ROE. In contrast, Research In Motion relies much more on high margins and asset turnover and less on leverage. Garmin's margins look attractive at first glance, but the industry is undergoing some huge shifts, and Garmin may not be part of them, despite its high ROE. Motorola Mobility, recently spun off, has a negative return on equity over the last year. Negative net margins were magnified by a high leverage ratio, but the company is working to turn things around.

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.

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