Return on equity is one of the top metrics on an investors’ mind, when they set out to select stocks, and quite rightly so. However, taking a step beyond the basic ROE and analyzing it at an advanced level could lead to better returns.
Yes, we are talking about DuPont analysis. It’s basically taking ROE apart to examine how it works. Here is how DuPont breaks down ROE into different components:
ROE = Net Income/Equity
Net Income / Equity = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity)
ROE = Profit Margin * Asset Turnover Ratio * Equity Multiplier
ROE vs DuPont
Although the importance of ROE can’t be stressed enough, the fact is that it always doesn’t 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 a company income statement and balance sheet.
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 5: 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 with a Zacks Rank #1 (Strong Buy) or 2 (Buy) generally outperform the market.
• 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 5 of the 10 stocks that made it through the screen:
Philip Morris International, Inc. (PM - Free Report)
Medifast Inc. (MED - Free Report)
H & M Hennes & Mauritz AB (HNNMY - Free Report)
The TJX Companies, Inc. (TJX - Free Report)
NVR, Inc. (NVR - Free Report)
Each of these picks has immense potential and the entire list is worth considering. 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.
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.
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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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