Return on equity (ROE) is one of the most-favored metrics of investors. It is a profitability ratio, which 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 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.
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. You can see . the complete list of today’s Zacks #1 Rank stocks here • 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 nine stocks that made it through the screen. Revolve Group ( RVLV Quick Quote RVLV - Free Report) : The Zacks Rank #2 e-commerce fashion company markets and sells men's and women's designer apparels, shoes and accessories.
The average earnings surprise of RVLV for the past four quarters is 96.26%.
Olympic Steel ( ZEUS Quick Quote ZEUS - Free Report) : The Zacks Rank #1 company is a leading U.S. metals service center focused on the direct sale and distribution of large volumes of processed carbon, coated and stainless flat-rolled sheet, coil and plate steel and aluminum products.
The average earnings surprise of ZEUS for the past four quarters is 49.65%.
Boise Cascade ( BCC Quick Quote BCC - Free Report) : The Zacks Rank #1 companyoperates as a wood products manufacturer and building materials distributor.
The average earnings surprise of BCC for the past four quarters is 48.4%.
Watsco ( WSO Quick Quote WSO - Free Report) : The Zacks Rank #1 company is the largest distributor of Heating, ventilation and air conditioning equipment, as well as related parts and supplies in North America.
The average earnings surprise of WSO for the past four quarters is 24.31%.
Cross Country Healthcare ( CCRN Quick Quote CCRN - Free Report) : The Zacks Rank #1 company is a national leader in providing innovative healthcare workforce solutions and staffing services.
The average earnings surprise of CCRN for the past four quarters is 41.52%.
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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