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 margins 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 Baidu (Nasdaq: BIDU) and a few of its sector and industry peers.

Company

Return on Equity

Net Margins

Asset Turnover

Leverage Ratio

SINA (Nasdaq: SINA)

46.3%

115.9%

0.31

1.30
Baidu

48.5%

41.5%

0.92

1.28
Sohu.com (Nasdaq: SOHU)

20.3%

23.8%

0.62

1.38
Google (Nasdaq: GOOG)

20.7%

29.0%

0.60

1.20

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

This group provides attractive returns on equity. Leverage ratios for these companies is in the same ballpark, so the critical differences will usually occur in either margins or asset turnover. Baidu leads this lot, in large part because of its gaudy margins. Google achieves lower margins and substantially less asset turnover, resulting in an ROE that is less than half of Baidu's. Sohu clocks in right around Google, using somewhat higher leverage to compensate for lower (but still great) margins. SINA's eye-popping margins are a result of a one-time gain on sale of assets. If you strip that sale out, then SINA is left with a much more prosaic 8% ROE.

Using the DuPont formula can often give you some insight into how a company is competing against its peers and what type of strategy it's using to juice return on equity.

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