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 liabilities 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 Kellogg (NYSE: K) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio






HJ Heinz (NYSE: HNZ)





ConAgra Foods (NYSE: CAG)





Sara Lee (NYSE: SLE)





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

The asset turnover of these companies falls within a narrow range, so the leverage ratio in net margins is going to be the key differentiator for their return on equity. Kellogg puts up the gaudy return on equity with attractive 9.9 % net margins and the highest leverage ratio of this group. Heinz follows close behind, with smaller margins and less leverage. Sara Lee uses similar leverage as Heinz, but its lower margins dampen its still impressive ROE. If ConAgra used as much leverage as Sara Lee, its ROE would be similarly high.

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 of the companies mentioned. HJ Heinz and Kellogg are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.