Return on equity is one of the most sought-after metrics for an investment. The metric enables investors to differentiate between a profit-churner and a profit-burner. It is a profitability ratio that measures the earnings a company generates from its equity.
To shortlist these gems, one can look at the DuPont technique to analyze the basic ROE at an advanced level. Here is 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 Importance of Du Pont
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 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.
Screening Parameters • 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 12 of 20 stocks that made it through the screen: MEDIFAST INC ( MED Quick Quote MED - Free Report) ): This Zacks Rank #2 company has become a remarkable direct-selling company in the industry. The company is also known for its leading health and wellness community — OPTAVIA — which provides Lifelong Transformation, One Healthy Habit at a Time lifestyle solutions. You can see . the complete list of today’s Zacks #1 Rank stocks here Builders FirstSource Inc. ( BLDR Quick Quote BLDR - Free Report) ): The Zacks Rank #2 company is a leading supplier and manufacturer of structural and related building products for residential new construction in the United States. C.H. Robinson Worldwide Inc. ( CHRW Quick Quote CHRW - Free Report) ): The companyis a third-party logistics company. The stock has a Zacks Rank #2. Landstar System, Inc. ( LSTR Quick Quote LSTR - Free Report) ):The company is an asset-light provider of integrated transportation management solutions. The stock has a Zacks Rank #2. AutoNation Inc. ( A Quick Quote A - Free Report) N): The company is the largest automotive retailer in the United States. It has a Zacks Rank #2.