How Do These Retailers Really Make Their Money?

As investors, we need to understand how our companies truly make their money. And there's a neat trick developed for just that purpose. It's called the DuPont Formula.

By using the DuPont Formula, you can get 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 DuPont Formula breaks down return on equity into three components.

Return on equity = Net margins X asset turnover X leverage ratio

High net margins show that a company is able to get customers to pay more for its products. Think luxury goods companies. High asset turnover indicates that a company needs to invest less of its capital, because it uses its assets more efficiently to generate sales. Think service industries, which often do not have high capital investments. Finally, the leverage ratio shows how much the company is relying on debt to create profit.

Generally, the higher these numbers, the better. Of course, too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's take a look at Wal-Mart (NYSE: WMT) and a few of its sector and industry peers.

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

TJX, the company behind brands such as T.J. Maxx, doubles Wal-Mart's return on equity, and you can easily see how here. TJX is able to wring net margins that are nearly double those of Wal-Mart, while each has about the same asset turnover and leverage ratio. Tiffany emphasizes higher margins and slower asset turnover. However, Abercrombie's numbers don't clearly show its strategy of charging high markups in exchange for slower asset turnover.

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