Now that the coronavirus-induced tensions can cause volatility in Wall Street at any point in time, the hunt for quality stocks has increased. In this respect, Return on Equity (ROE) is often the most favored metric.
It is a profitability ratio that measures earnings generated by a company from its equity. Investors can follow the ROE trend in companies and compare this to historical or industry benchmarks to pick a winning stock.
However, stepping beyond the basic ROE and analyzing it at an advanced level could lead to even better returns. Here is where the DuPont analysis comes into play.It is an analytical method, which examines three major elements – operating management, management of assets and the capital structure – related to the financial condition of a company. Below we show how DuPont breaks down ROE into its different components:
ROE = Net Income/Equity
Net Income / Equity = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity) ROE = Profit Margin * Asset Turnover Ratio * Equity Multiplier Why Use DuPont?
Although one can’t play down the importance of normal ROE calculation, the fact remains that it doesn’t always provide a complete picture. The DuPont analysis, on the other hand, allows investors to assess the elements that play a dominant role in any change in ROE. It can help investors to segregate companies having higher margins from those having high turnover. For example, high-end fashion brands generally survive on high margin as 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, the strength of a company can be misleading if it has a high debt load.
So, an investor confined solely to an ROE perspective may be confused if he or she has to judge between two stocks of equal ratio. This is where DuPont analysis wins over and spots the better stock.
Investors can simply do this analysis by taking a look at the company’s financials.However, looking at the financial statements of each company separately can be a tedious task. Screening tools like Zacks Research Wizard can come to your rescue and help you shortlist the stocks that look impressive with 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 11 stocks that made it through the screen: MEDIFAST INC ( MED Quick Quote MED - Free Report) ): This Zacks Rank #1 company is a leading manufacturer and distributor of clinically proven healthy living products and programs. You can see . the complete list of today’s Zacks #1 Rank stocks here Systemax Inc. ( SYX Quick Quote SYX - Free Report) ): This Zacks Rank #2 company is a direct marketer of brand name and private label products, including personal desktop computers, notebook computers, computer-related products, and industrial products, in North America and Europe. USANA Health Sciences Inc. ( USNA Quick Quote USNA - Free Report) ): This Zacks Rank #2 company develops and manufactures high-quality nutritional, personal care and weight-management products. Humana Inc. ( HUM Quick Quote HUM - Free Report) ): The company is one of the largest healthcare plan providers in the United States. It has a Zacks Rank … XPEL Inc. ( XPEL Quick Quote XPEL - Free Report) ): This is a provider of protective films and coatings, which include automotive paint protection film, surface protection film, automotive and architectural window films and ceramic coatings. It carries a Zacks Rank #1.
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