How Do These Travel Services 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 priceline.com (Nasdaq: PCLN) and a few of its sector and industry peers.

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

Priceline gets the gaudy return on equity: net margins are attractive, and the company uses high asset turnover and moderate leverage to make ROE soar. Despite its very high leverage ratio, Orbitz achieves a lackluster ROE, due in large part to low net margins. Expedia has a similar asset turnover to Orbitz and much less leverage, but its higher net margins allow the company to post a solid ROE. Ctrip has unbelievably high margins, but falls well short of Priceline's ROE. Significantly less asset turnover looks to be a key reason.

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.