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 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
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 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:
Walmart Inc. WMT: This Zacks Rank #2 company has evolved from just being a traditional brick-and-mortar retailer into an omnichannel player. You can see the complete list of today’s Zacks #1 Rank stocks here.
Boise Cascade L.L.C. BCC: The companyoperates as a wood products manufacturer and building materials distributor. The stock carries a Zacks Rank #1.
AllianceBernstein Holding L.P. AB: The company provides diversified investment management services, primarily to pension funds, endowments, foreign financial institutions, and individual investors. The stock has a Zacks Rank #2.
Robert Half International Inc. RHI: The Zacks Rank #2 company is one of the world's largest providers of professional consulting and staffing services.
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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.
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Walmart Inc. (WMT) : Free Stock Analysis Report
AllianceBernstein Holding L.P. (AB) : Free Stock Analysis Report
Robert Half International Inc. (RHI) : Free Stock Analysis Report
Boise Cascade, L.L.C. (BCC) : Free Stock Analysis Report
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