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 Manitowoc (NYSE: MTW) and a few of its sector and industry peers:

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Manitowoc

(9.5%)

(2.7%)

0.82

8.08

Illinois Tool Works (NYSE: ITW)

21.2%

11.2%

1.03

1.85

Cooper Industries (NYSE: CBE)

25.0%

15.3%

0.86

1.89

Terex (NYSE: TEX)

0.2%

0%

0.90

2.99

Source: S&P Capital IQ.

Manitowoc recorded a negative return on equity, or ROE, over the last four quarters. While its asset turnover sits in the range of peers', its high leverage exacerbates the negative net margin and so a move to positive margins would see its ROE skyrocket. With roughly similar asset turnover and leverage, Illinois Tool and Cooper come down to the difference in margin to determine which has the highest ROE. But Cooper manages to squeeze higher margins, though ITW's double digit figure is quite good, too. While Terex hits an asset turnover in the range of peers' and higher leverage than Cooper and ITW, its flat margin leads to an uninspiring 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.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.