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 Diageo (NYSE: DEO) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio






Boston Beer (NYSE: SAM)





Molson Coors Brewing (NYSE: TAP)





Constellation Brands (NYSE: STZ)





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

Diageo puts up the gaudy ROE numbers, with attractive net margins, but it's the company's leverage ratio that really adds color to its numbers. Compare it to Molson Coors, where an even better net margin translates into a lower ROE because of lower asset turnover and a lower leverage ratio. Boston Beer achieves a nice ROE with solid net margins, but its asset turnover really makes it stand out from this crowd. Constellation doesn't really have a stellar return on equity, especially since it uses leverage to boost its figures.

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. Molson Coors Brewing is a Motley Fool Inside Value pick. Boston Beer is a Motley Fool Stock Advisor recommendation. Diageo is a Motley Fool Income Investor selection. The Fool owns shares of Diageo and Molson Coors Brewing. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.