Return on Equity (ROE) is one of the most coveted metrics by investors. 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.
To shortlist these gems, one can look at the DuPont technique to analyze basic ROE at an advanced level. 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.
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 lower priced stocks, this criterion can be removed.
Here are all five stocks that made it through the screen:
BMC Stock Holdings Inc. (BMCH - Free Report) : This Zacks Rank #1 company provides diversified building products and services to professional builders and contractors primarily in the residential housing market. It belongs to a favorable Zacks industry (placed at the top 17% of 250+ industries). You can see the complete list of today’s Zacks #1 Rank stocks here.
USANA Health Sciences Inc. (USNA - Free Report) : This Zacks Rank #2 company develops and manufactures high-quality nutritional, personal care and weight management products. It belongs to a favorable Zacks industry (top 29%).
Universal Forest Products Inc. (UFPI - Free Report) : The Zacks Rank #1 holding company with its subsidiaries operates throughout North America, Europe, Asia and Australia. The company supplies wood, wood composite and other products in retail, industrial and construction markets.
NVR Inc. (NVR - Free Report) : This is engaged in the construction and sale of single-family detached homes, townhomes and condominium buildings, all of which are primarily constructed on a pre-sold basis. It comes from a favorable Zacks industry (top 10%).
Vipshop Holdings Limited (VIPS - Free Report) : This is an online discount retailer for brands. It carries a Zacks Rank #2.
You can sign 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.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.