Return on equity (ROE) is one of the most popular ratios that investors use to single out healthy stocks. It is a profitability ratio that measures the earnings that a company generates from its equity.
However, taking a step beyond basic ROE and analyzing it at an advanced level could lead one to stocks that offer better returns.
Yes, we are talking about DuPont analysis. It is an analytical method, which critically examines three major elements — operating management, management of assets and the capital structure — related to the financial condition of a company.
It’s basically taking ROE apart to examine how it works. Although it can be presented in several ways, the most popular one is shown below:
- ROE = Net Income/Equity
- Net Income / Equity = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity)
- ROE = Profit Margin * Asset Turnover Ratio * Equity Multiplier
DuPont versus ROE
The importance of ROE can’t be said but still it doesn’t always provide a complete picture. The DuPont analysis on the other hand allows investors to assess which of the elements is dominant in any change in ROE. It can help investors to segregate companies having high margins from those having high turnover. For example, high end fashion brands generally survive on high margins compared with retail goods, which rely on higher turnover.
In fact, it also sheds light on the company’s leverage status, which can go a long way in selecting stocks poised for gains. A lofty ROE could be due to the overuse of debt. Thus, ROE of a company can be misleading if it has a high debt burden.
So, an investor confined solely to an ROE perspective will be at a loss if he or she has to judge between two stocks of equal ratio. This is where DuPont analysis comes to the rescue and finds out the better stock. Thus, a company with a healthy mix of all the three metrics – profit margin, asset turnover ratio and equity multiplier – will be the most alluring.
DuPont analysis is not difficult, as the required numbers are available in a company’s income statement and balance sheet.
However, looking at the financial statements of each and every company separately can be a tedious task. Screening tools like Zacks Research Wizard can easily shortlist the stocks that look impressive based on a DuPont analysis.
• Profit Margin more than or equal to 3: As the name suggests, it is a measure of how profitably the business is running. Generally, it is the key contributor to ROE.
• Asset Turnover Ratio more than or equal to 2: It allows an investor to assess management’s efficiency in using assets to drive sales.
• Equity Multiplier between 1 and 3: It’s an indication of how much debt the company uses to finance its assets.
• Zacks Rank less than or equal to 2: Stocks having a Zacks Rank #1 (Strong Buy) or 2 (Buy) generally perform better than their peers in all types of market environment.
• Current Price more than $5: This screens out the low priced stocks. However, when looking for lower priced stocks, this criterion can be removed.
Here are five of the seven stocks that made it through the screen…
Francesca’s Holdings Corp (FRAN) is one of the fastest growing specialty retailers in the U.S. This Zacks Rank #1 company’s earnings are expected to grow at a rate of 15.8% for this year compared with the industry average of 1.5%.
Thor Industries, Inc. (THO) is one of the largest manufacturers of recreational vehicles globally. THO has an average four-quarter positive earnings surprise of 24.1%. The stock sports a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
Calavo Growers, Inc. (CVGW) is the avocado-industry leader on a global scale. The company is also engaged in procuring and marketing diversified fresh produce items such as tomatoes and tropical produce. Its earnings are expected to grow at a rate of 14.8% this year. The stock has a Zacks Rank #1.
Landstar System, Inc. (LSTR) is a global worldwide, asset-light provider of integrated transportation management solutions. This Zacks Rank #2 company has an expected EPS growth rate of 14% for the next five years.
Watsco Inc (WSO), the largest distributor of air conditioning, heating and refrigeration equipment and related parts and supplies in the U.S., carries a Zacks Rank #2. The company’s earnings are expected to grow at a rate of 11.5% this year compared with the industry average of 8.2% next year.
You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge.
The Research Wizard is a great place to begin. It’s easy to use. Everything is in plain language. And it’s very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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