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 Cypress Semiconductor (Nasdaq: CY) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Cypress Semiconductor

19.6%

12.9%

0.94

1.59

Analog Devices (NYSE: ADI)

27.3%

29.5%

0.66

1.40

Linear Technology (Nasdaq: LLTC)

318.5%

36.7%

0.95

9.11

National Semiconductor (NYSE: NSM)

46.8%

19.7%

0.65

3.66

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

The numbers here are all strong. The most eye-catching ROE is Linear Tech's, derived from a high net margin, relatively high asset turnover, and very high leverage. National Semiconductor puts up a much better ROE than Analog Devices, but not because of better margins. National Semi's focus on higher leverage is key, since both players have similar asset turnover. Cypress uses moderate leverage, but its solid margin leads still helps it achieve a good ROE.

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 .

We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Jim Royal, Ph.D., owns no shares in any company mentioned. Motley Fool newsletter services have recommended buying shares of Linear Technology and Cypress Semiconductor. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.