Wall Street is at lofty levels with stupendous equity gains in 2019. Naturally, fears of a correction are understandable. Since market watchers are still predicting decent gains in equities in 2020, it would be wise to bet on quality stocks right now.
Return on equity (ROE) is one of the most-favored quality metrics of investors. It is a profitability ratio that 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, namely operating management, management of assets and capital structure to find out 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
Why Use DuPont?
Although one cannot brush off the importance of normal ROE calculation, the fact remains that it doesn’t always portray 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 with higher margins from those having a high turnover. For example, high-end fashion brands generally survive on high margins compared with retail goods, which rely on a higher turnover.
And one of the ROE components – equity multiplier (explained below) – can help you judge how burdened a company is with debts. 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 a 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 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:
Calavo Growers Inc. (CVGW - Free Report) ): This Zacks Rank #1 company is a global avocado-industry leader and an expanding provider of value-added fresh food. It belongs to a favorable Zacks industry (placed at the top 35% of 250+ industries). You can see the complete list of today’s Zacks #1 Rank stocks here.
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 (top 36%).
Humana Inc. (HUM - Free Report) ): The Zacks Rank #2 holding company is one of the largest health care plan providers in the United States. It comes from a favorable Zacks industry (top 15%).
Vipshop Holdings Limited (VIPS - Free Report) : This is an online discount retailer for brands. The stock carries a Zacks Rank #1. It hails from a favorable Zacks industry (top 34%).
AllianceBernstein Holding L.P. (AB - Free Report) ): The Zacks Rank #2 company provides diversified investment management services, primarily to pension funds, endowments, foreign financial institutions and to individual investors. It comes from a favorable Zacks industry (top 18%).
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.