Return on equity (ROE) is one of the top metrics on investors’ mind when they set out to select stocks, and quite rightly so. It is a profitability ratio that measures the earnings of a company from its equity.
However, delving into the basics of ROE and analyzing it at a deeper level, with the help of DuPont analysis, could lead to better returns. It is an analytical method, which critically examines three major elements – operating management, management of assets and the capital structure – related to the financial condition of a company. It’s basically taking ROE apart to examine how it works. Although it can be presented in several ways, the most popular one is shown below:
ROE = Net Income/Equity
Net Income / Equity = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity)
ROE = Profit Margin * Asset Turnover Ratio * Equity Multiplier
The importance of ROE can’t be emphasized enough but still it doesn’t always provide a complete picture. 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 with high margins from those with high turnover. For example, high end fashion brands generally survive on high margin 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 confined solely to an ROE perspective will be at a loss if he or she has to judge between two stocks of equal ratio. DuPont analysis comes to the rescue and finds out the better stock. Thus, a company with a healthy mix of all the three metrics – profit margin, asset turnover ratio and equity multiplier – will be the most alluring.
DuPont analysis is not difficult, as the required numbers are available in a company’s income statement and balance sheet.
However, looking at the financial statements of each and every company separately can be a tedious task. Screening tools like Zacks Research Wizard can easily shortlist the stocks that look impressive based on 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 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 five of the eleven stocks that made it through the screen:
Winnebago Industries, Inc. (WGO - Free Report) enjoys a leading position as the manufacturer of vehicles, which are used primarily in leisure travel and outdoor recreation activities in the U.S. This Zacks Rank #1 company’s earnings are expected to grow at a rate of 32.3% for this year.
Thor Industries Inc. (THO - Free Report) is one of the largest manufacturers of recreational vehicles globally. Thor has an average four-quarter positive earnings surprise of 22.3%. The stock has a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
Hibbett Sports, Inc. (HIBB - Free Report) operates sporting goods stores in small to mid-sized markets in the South, Southwest, Mid-Atlantic and lower Midwest regions of the U.S. and carries a Zacks Rank #2. The company has an average four-quarter positive earnings surprise of about 3.9%.
Nutrisystem, Inc. (NTRI - Free Report) is a leader in the weight loss industry and has a number of weight loss management products including Nutrisystem My Way, Fast 5, and Turbo 10 in its kitty. Its earnings are expected to grow at a rate of 33.7% for this year. The stock has a Zacks Rank #2 (Buy).
Marcus & Millichap, Inc. (MMI - Free Report) , a leading national brokerage firm focused on commercial real estate investment sales, financing, research and advisory services, carries a Zacks Rank #2. The company has an expected EPS growth rate of 10.5% for the next five years, higher than the industry average of 8.7%.
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. Further, you can also create your own strategies and test them first before taking the investment plunge.
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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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