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 International Business Machines (NYSE: IBM) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

International Business Machines

67.2%

14.9%

0.93

4.86

Accenture (NYSE: ACN)

60.0%

8.0%

1.92

3.44

Infosys Technologies (Nasdaq: INFY)

26.1%

24.8%

0.92

1.15

Wipro (NYSE: WIT)

24.4%

17.1%

0.89

1.61

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

IBM scores the highest ROE of this group, but not because it has the highest margin. Big Blue uses a high leverage ratio to boost its solid margins and average asset turnover. Accenture's net margin is about half of IBM's, but the company uses much higher asset turnover and considerable leverage to achieve a stellar return on equity. Infosys' margins lead this group, but its much lower leverage leaves it with a lower, though still respectable, ROE. Wipro tells a similar story, sporting lower margins but using more leverage than Infosys.

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. The Motley Fool owns shares of IBM. Motley Fool newsletter services have recommended Accenture. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.