Return on equity (ROE) is one of the most favored 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 – operating management, management of assets and 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
The screener yields winning stocks like W.W. Grainger (GWW), Olympic Steel (ZEUS), Sprouts Farmers Market (SFM), Veritiv (VRTV) and Phillips 66 (PSX).
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.
Screening Parameters
• 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 environments.
• 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 five of the 11 stocks that made it through the screen:
W.W. Grainger (GWW): This Zacks Rank #2 company is a broad-line, business-to-business distributor of maintenance, repair and operating (MRO) products and services. You can see the complete list of today’s Zacks #1 Rank stocks here.
The average earnings surprise of GWW for the past four quarters is 9.81%.
Olympic Steel (ZEUS): The Zacks Rank #1 company is a leading U.S. metals service center focused on the direct sale and distribution of large volumes of processed carbon, coated and stainless flat-rolled sheet, coil and plate steel and aluminum products.
The average earnings surprise of ZEUS for the past four quarters is 26.19%.
Sprouts Farmers Market (SFM): The Zacks Rank #2 company operates in a highly fragmented grocery store industry, has a unique model that features fresh produce, a foods section and a vitamin department focused on overall wellness.
The average earnings surprise of SFM for the past four quarters is 12.54%.
Veritiv (VRTV): The Zacks Rank #1 company engages in offering North American business-to-business distribution solutions. It provides packaging, print and print management, publishing, supply chain, facility and logistics solutions that span the entire lifecycle of core business operations.
The average earnings surprise of VRTV for the past four quarters is 20.69%.
Phillips 66 (PSX): The Zacks Rank #2 company’s operations incorporate refining, midstream, marketing and specialties, and chemicals.
The average earnings surprise of PSX for the past four quarters is 13.01%.
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.
Click here to sign up for a free trial to the Research Wizard today.
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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