How Do These Defense Companies Really Juice Their Returns?

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

The DuPont formula can help you 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 that pioneered it, 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, since it uses its assets more efficiently to generate sales. (Think service industries, which often lack high capital investments.) Finally, the leverage ratio shows how heavily the company relies on debt to create profit.

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

Let's take a look at Boeing (NYSE: BA) and a few of its sector and industry peers.

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

The net margins here as well as the asset turnover are within a fairly narrow range. Although Boeing puts up the gaudy return on equity, you can quickly see how it performs the feat -- by flying on just a sliver of equity and a lot of leverage. Lockheed pulls a similar feat, juicing ROE with a very high leverage ratio. Northrop and Raytheon run at more typical leverage, with Raytheon edging out its peer (and this group) on net margins, and still get respectable returns on equity.

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.

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