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 AutoZone (NYSE: AZO) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

AutoZone

NM

10.1%

1.37

(8.47)

Advance Auto Parts (NYSE: AAP)

27.3%

5.7%

1.77

2.69

O'Reilly Automotive (Nasdaq: ORLY)

13.6%

7.3%

1.08

1.71

Pep Boys (NYSE: PBY)

6.9%

1.6%

1.29

3.33

Source: Capital IQ, a division of Standard & Poor's. NM = not measurable

Just looking at return on equity without context could be misleading. AutoZone has an indefinable ROE because it runs with negative equity, due to a huge slug of treasury stock. That results in the negative leverage ratio. But as you can see, its net margins are the highest of the bunch. Advance puts a great ROE, even with much lower margins, thanks to a good chunk of leverage and the highest asset turnover here. O'Reilly achieves better margins than Advance, but its lower asset turnover and leverage puts its ROE at just half of Advance. Pep Boys achieves a so-so ROE, thanks largely to its low margins, since leverage is relatively high and asset turnover is in the middle of this group.

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.  Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.