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 Best Buy (NYSE: BBY) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Best Buy

19.2%

2.5%

2.78

2.54

Kohl's (NYSE: KSS)

14.1%

6.1%

1.39

1.67

GameStop (NYSE: GME)

14.5%

4.3%

1.89

1.78

Gap (NYSE: GPS)

26.8%

8.2%

1.95

1.68

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

Gap has the highest ROE of these four companies, with net margins far higher than its competitors'. Best Buy has the second highest ROE, by focusing on higher asset turnover and leverage. GameStop and Kohl's achieve mid-teens ROE, one through relatively higher margin and the other through a focus on higher asset turnover.  

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.