In a market where complacency levels may falter any time thanks to central banks’ moves, geo-political concerns and overvaluation issues, picking the right stock is a challenge. The metric return on equity goes a long way in resolving this issue.
The metric enables investors to differentiate between a profit-churner and a profit-burner. It is a profitability ratio that measures the earnings that a company generates from its equity.
But to fine-tune this basic concept, one can land on DuPont analysis. This theory will take investors a step higher and better pick some quality stocks.
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
Why Use DuPont?
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.
• Current Price more than $5: This screens out the low-priced stocks. However, when looking for stocks priced lower, this criterion can be removed.
Here are five of 12 stocks that made it through the screen:
Sanderson Farms Inc. (SAFM - Free Report) : This Zacks Rank #1 poultry processing company belongs to a Zacks Industry Rank in the top 5%. You can see the complete list of today’s Zacks #1 Rank stocks here.
Nutrisystem Inc. : This Zacks Rank #1 company is a provider of weight management products and services. It belongs to a Zacks Industry Rank is in the top 11%.
NVR Inc (NVR - Free Report) : The Zacks Rank #2 holding company operates in two business segments: construction and marketing of homes, and financial services. It belongs to a Zacks Industry Rank in the top 17%.
Five Below Inc. (FIVE - Free Report) : It is a specialty value retailer offering merchandise for teen and pre-teen customers in the United States. The stock carries a Zacks Rank #2. Though the Zacks Industry Rank is in the bottom 12%, the stock has a VGM score of A.
American Woodmark Corporation (AMWD - Free Report) : This is a manufacturer of kitchen cabinets and vanities for the remodeling and new home construction markets. It has a Zacks Rank #2 and the Zacks Sector Rank is in the top 38%. The stock has a VGM score of A.
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.
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.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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