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 Compass Diversified Holdings (NYSE: CODI) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Compass Diversified Holdings (7.0%) (2.3%) 1.82 1.84
DDI (Nasdaq: DDIC) 26.4% 8.1% 2.03 1.60
Paychex (Nasdaq: PAYX) 35.6% 24.7% 0.39 3.66
Automatic Data Processing (Nasdaq: ADP) 20.1% 12.8% 0.25 6.31

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

Compass turns in a negative return on equity, but high asset turnover and reasonable leverage should really juice ROE when the net margin turns positive. You can see a similar effect with DDI, which has similar asset turnover and leverage. Paychex leads this group in ROE because of its high margin and leverage. Automatic Data Processing runs with even higher leverage, but its lower margin and asset turnover bring down 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. If you'd like to add these companies to your watchlist, or set up a new one, just click here.

Jim Royal, Ph.D., does not own shares in any company mentioned. Motley Fool newsletter services have recommended buying shares of Paychex and Automatic Data Processing. 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.