How Do These Steelmakers Really Earn Their Cash?

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 ArcelorMittal (NYSE: MT) and a few of its sector and industry peers.

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

In the last four quarters, the ROEs here are all over the map. South Korea's POSCO leads this group, in large part due to its net margins since its leverage ratio is the lowest. ArcelorMittal runs at a bit high leverage ratio but gets smaller margins. Nucor gets a razor-thin margin, which is offset by much higher asset turnover. U.S. Steel's leverage ratio, the highest among this group, cuts both ways: magnifying the company's negative net margins in bad times and boosting them in good times.

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.