With global markets suffering due to the coronavirus attack, it is very important now to remain alert at the time of stock picking. While doing so, a look at the return-on-equity (ROE) ratio would be a good strategy.
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, delving a little deeper into the basic ROE and analyzing it at an advanced level could lead to even better returns. Here is where the DuPont analysis excels.It is an analytical method, which examines three major elements – operating management, management of assets and the capital structure – related to 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
Importance of Using 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 margin as compared with retail goods, which rely on 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 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 four stocks that made it through the screen:
Calavo Growers Inc. (CVGW - Free Report) : This Zacks Rank #1 company is a global avocado-industry leader. It belongs to a favorable Zacks industry (placed at the top 33% of 250+ industries). You can see the complete list of today’s Zacks #1 Rank stocks here.
BMC Stock Holdings Inc. (BMCH - Free Report) : The companyprovides diversified building products and services to professional builders and contractors primarily in the residential housing market. The stock carries a Zacks Rank #2. It hails from a favorable Zacks industry (top 26%).
Vipshop Holdings Limited (VIPS - Free Report) : The Zacks Rank #1 companyis an online discount retailer for brands. It is from a favorable Zacks industry (top 6%).
AllianceBernstein Holding L.P. (AB - Free Report) : The company provides diversified investment management services, primarily to pension funds, endowments, foreign financial institutions, and individual investors. The stock carries a Zacks Rank #2. It belongs to a favorable Zacks industry (top 4%).
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.