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 Caterpillar (NYSE: CAT) and a few of its sector and industry peers.


Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

Caterpillar 22.1% 5.2% 0.62 6.88
Deere (NYSE: DE) 33.6% 7.2% 0.62 7.60
Illinois Tool Works (NYSE: ITW) 19% 10.6% 0.99 1.82
Ingersoll-Rand (NYSE: IR) 8.9% 4.1% 0.68 2.75

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

Caterpillar achieves a solid return on equity, using a high leverage ratio to offset mid-single digit margins. Deere beats Cat, turning a higher margin and more leverage into a still-higher ROE. Despite much lower leverage, Illinois Tool Works also puts up an impressive return, using double-digit margins and a significantly high asset turnover. Ingersoll-Rand's leverage ratio isn't high enough to offset its low margins, leaving ROE at a less-than-impressive level.

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. Illinois Tool Works is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.