As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont Formula -- can help us do so.

The DuPont Formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:

Return on equity = net margin X asset turnover X leverage ratio

What makes each of these components important?

  • High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
  • High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
  • Finally, the leverage ratio shows how much the company is relying on liabilities to create its profits.

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 see what the DuPont Formula can tell us about Home Depot (NYSE: HD) and a few of its sector and industry peers.

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Home Depot

17.4%

4.9%

1.68

2.12
Lowe's (NYSE: LOW)

10.8%

4.1%

1.46

1.79
Lumber Liquidators (NYSE: LL)

16.0%

4.2%

2.77

1.36
Tractor Supply (Nasdaq: TSCO)

21.2%

4.7%

2.58

1.76

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

In an intense retail environment, the margins at these retailers all sit in the 4% range, so any differences in ROE will have to primarily come from asset turnover and leverage. Home Depot beats out key rival Lowe's by using higher asset turnover and more leverage. Lumber Liquidators focuses on asset efficiency to achieve an ROE nearly as good as Home Depot's, despite lower leverage. Tractor Supply scores the best return on equity of this group by maintaining high numbers in all categories. 

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. To find more successful investments, dig deeper than the earnings headlines. And if you'd like to, add these companies to your watchlist.