In a market where complacency levels may falter any time if there is a second wave of virus contagion and medical metrics worsen, 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 lower priced stocks, this criterion can be removed.
Here are all the three stocks that made it through the screen:
Medifast Inc (MED - Free Report) ): This Zacks Rank #1 manufacturer and distributor of clinically proven healthy living products and programs belongs to afavorable Zacks industry (placed at the top 15% of total 250+ industries in the Zacks universe). You can see the complete list of today’s Zacks #1 Rank stocks here.
Humana Inc. (HUM - Free Report) ): This Zacks Rank #2 company is one of the largest health care plan providers in the United States. It hails from a favorable Zacks industry (top 31%).
Vipshop Holdings Limited (VIPS - Free Report) ): The Zacks Rank #2 company is an online discount retailer for brands. It belongs to a favorable Zacks industry (top 16%).
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.