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 ResMed (NYSE: RMD) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

ResMed

14.8%

18.6%

0.65

1.23

Accuray (Nasdaq: ARAY)

1.9%

1.6%

0.80

1.52

CONMED (Nasdaq: CNMD)

5.4%

4.4%

0.73

1.67

Varian Medical Systems (NYSE: VAR)

29.3%

15.9%

1.02

1.78

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

The returns on equity run the scale here, due largely to differences in asset turnover and margin. While ResMed scores the highest margin among this group, it doesn't have the highest ROE. That honor belongs to Varian, which uses more leverage and asset turnover to double ResMed's ROE. Accuray and CONMED achieve lackluster returns on equity, due largely to low net margins, since their other figures are largely in line with peers'.

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.