Return on equity (ROE) is one of the most coveted metrics among investors in search of profit-generating stocks. Delving into the basic ROE, with the help of DuPont analysis, before shortlisting stocks could lead to even better returns. It’s basically taking ROE apart to examine how it works. 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
Inside DuPont’s Effectiveness
Although one can’t stress the importance of ROE enough, the fact remains that it doesn’t always provide a complete picture. But the DuPont analysis 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 margin as compared with retail goods which rely on higher turnover.
In fact, it also sheds light on a 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 looking at two stocks only from an ROE perspective will be impartial if the values are the same. However, DuPont analysis will help to differentiate between the two stocks and find the better one. Thus, a company with a healthy mix of all the three ratios – profit margin, asset turnover ratio and equity multiplier – will be the most alluring.
DuPont analysis is not very difficult, as the required numbers are available in the company income statement and balance sheet of a company.
However, looking at financial statements of each company separately can be a tedious task. Screening tools like Zacks Research Wizard can easily 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 17 stocks that made it through the screen: Sanderson Farms Inc. (This is Zacks Rank #1 company is engaged in poultry processing. You can see SAFM Quick Quote SAFM - Free Report) : . the complete list of today’s Zacks #1 Rank stocks here Pool Corporation (This Zacks Rank #2 company is the world's largest wholesale distributor of swimming pool supplies, equipment and related products. POOL Quick Quote POOL - Free Report) : Caseys General Stores Inc. (The Zacks Rank #1 company operates convenience stores under the Casey's and Casey's General Store names in 16 Midwestern states, mainly Iowa, Missouri and Illinois. CASY Quick Quote CASY - Free Report) : XPEL Inc. (This provider of protective films and coatings, which include automotive paint protection film, surface protection film, automotive and architectural window films and ceramic coatings, carries a Zacks Rank #1. XPEL Quick Quote XPEL - Free Report) : Watsco Inc. (The Zacks Rank #2 company is the largest distributor of Heating, ventilation and air conditioning equipment, as well as related parts and supplies (HVAC/R) in North America. WSO Quick Quote WSO - Free Report) :
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. Click here to sign up for a free trial to the Research Wizard today 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. Disclosure: Performance information for Zacks’ portfolios and strategies are available at: . https://www.zacks.com/performance