How Do These Defense Contractors Really Earn Their Cash?

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 liabilities 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 United Technologies (NYSE: UTX) and a few of its sector and industry peers.

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

There are solid returns on equity from these players in the defense space. Harris beats out United Technologies in ROE, using much better margins and higher asset turnover to compensate for less leverage. Honeywell offsets its lower margins with higher leverage, and just edges General Dynamics. General Dynamics' numbers look pretty comparable to United Technologies', with somewhat less leverage being offset by higher asset turnover.

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.