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. That said, 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 Dollar General (NYSE: DG) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Dollar General

16.9%

4.8%

1.42

2.47

Family Dollar Stores (NYSE: FDO)

28.7%

4.6%

2.81

2.24

Dollar Tree (Nasdaq: DLTR)

27.5%

6.8%

2.52

1.62

99 Cents Only Stores (NYSE: NDN)

11.8%

5.3%

1.80

1.24

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

Somewhat surprisingly, the margins in this space beat out those of some of the best retail operators. The numbers are all over the place, although margins do cluster somewhat around 5%. Dollar General's solid ROE sits about in the middle of this group, despite its relatively low asset turnover. Family Dollar sports a great return on equity, with asset turnover being the key difference between it and Dollar General. Dollar Tree notches similar ROE to Family Dollar, but manages to squeeze out even higher margins and does it with less leverage. 99 Cents Only achieves a middling ROE despite decent margins, largely because of low leverage.

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. If you'd like to add these companies to your watchlist, or set up a new one, just click here .

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Jim Royal, Ph.D., does not own shares in any company mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.