A company with a favorable efficiency level is expected to provide impressive returns as it is believed to be positively correlated with the company's price performance. Efficiency, which is the ability to transform inputs into outputs, is a potential indicator of a company’s financial health.
However, it is difficult to measure the efficiency level of a company. This is the reason why one must consider popular efficiency ratios while selecting stocks to build a profitable portfolio.
How to Measure Efficiency?
We have considered four popular ratios in order to find efficient companies that have the potential to provide impressive returns.
Inventory level is one of the key indicators of a company’s business health. While a high inventory level may indicate that the company is going through a rough phase in terms of sales, a dwindling level may indicate that the company will run out of stock in a favorable sales condition. This is where inventory turnover comes into play. It is the ratio of 12-month cost of goods sold (COGS) to a 4-quarter average inventory. Thus, a high value of the ratio indicates a low level of inventory relative to COGS, while a low ratio signals that the company has excess inventory.
This ratio is used to measure a company’s capability to extend its credit and collect debts on the basis of that credit. Receivables turnover ratio or the “accounts receivable turnover ratio” or the “debtor’s turnover ratio” is calculated by dividing 12-month sales by four-quarter average receivables. While a high ratio indicates that the company efficiently collects its accounts receivables or has quality customers, a low ratio signals that the company has an inefficient collection procedure or has low-quality customers or an inefficient credit policy.
This is a widely used measure of a company’s efficiency. Asset utilization indicates a company’s potential to utilize its assets. It is a ratio of total sales over the past 12 months to the last 4-quarter average of total assets. So, the higher the ratio, the greater is the chance that the company is utilizing its assets efficiently. On the contrary, a low value of the ratio signals that it is failing to use its assets effectively.
Another popular efficiency ratio is the operating margin. Operating profit margin, which is simply operating income over the past 12 months divided by sales over the same period, indicates how well a company is controlling its operating expenses. If a company has a high operating profit margin in relation to its competitors, it is doing a better job at controlling operating expenses.
All these ratios can be considered as effective measures if one compares different companies within a particular sector or industry. This is the reason why we have considered only those companies that have higher ratios than their respective industry averages.
In addition to the above mentioned ratios, we have added a favorable Zacks Rank — Zacks Rank #1 (Strong Buy) or 2 (Buy) — to the screen with an objective to make this strategy more profitable.
Inventory Turnover, Receivables Turnover, Asset Utilization and Operating Margin greater than industry average
(Values of these ratios higher than industry averages may indicate that the efficiency level of the company is higher than its peers.)
Zacks Rank better than or equal to #2 (Buy)
(Only Zacks Rank #1 and Buy-rated stocks can get through.)
The use of these few criteria has narrowed down the universe of over 7,904 stocks to only 13. Here are five of the 15 stocks that passed the screen.
Athletic apparel companyLululemon Athletica Inc. LULU, together with its subsidiaries, designs, distributes, and retails athletic apparel and accessories for women, men, and female youth. The company sports a Zacks Rank #1. The company has an average four-quarter positive earnings surprise of 8.1%.
Chemed Corporation CHE provides hospice and palliative care services in the United States. The company has a Zacks Rank #2. It has an average four-quarter positive earnings surprise of 5.9%. You can see the complete list of today’s Zacks #1 Rank stocks here.
Baxter International Inc. BAX provides a portfolio of renal and hospital products. The company has a Zacks Rank #2. It has an average four-quarter positive earnings surprise of 10.6%.
NVR, Inc. NVR operates as a homebuilder in the United States. The company operates through four segments: Mid Atlantic, North East, Mid East and South East. The company has a Zacks Rank #2. It has an average four-quarter positive earnings surprise of 17.2%.
Copart, Inc. CPRT provides online auctions and vehicle remarketing services. The company has a Zacks Rank #1. It has an average four-quarter positive earnings surprise of 10.7%.
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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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