Return on equity is an investor-favorite metric when it comes to cherry-picking quality stocks. But ROE doesn’t always tell the complete story and an investor might make a mistake by selecting stocks based on this ratio. Thus, taking a step beyond the basic ROE and analyzing it at an advanced level or applying the DuPont technique seem a prudent decision.
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 five of the 10 stocks that made it through the screen:
Medifast Inc MED: This company has a Zacks Rank #2 and is a leading manufacturer and distributor of clinically proven healthy living products and programs. You can see the complete list of today’s Zacks #1 Rank stocks here.
Shoe Carnival Inc. SCVL: This company carries a Zacks Rank #2 and is one of the nation's largest family footwear retailers, offering a broad assortment of moderately priced dress, casual and athletic footwear for men, women and children with emphasis on national and regional name brands. It belongs to a top-ranked Zacks sector (top 36%).
Marine Products Corporation MPX: This Zacks #2 Ranked company is the third-largest distributor of sterndrive powerboats in the United States. It belongs to a top-ranked Zacks industry (top 7%).
Amedisys Inc. AMED: This provider of healthcare in the home holds a Zacks Rank of 2. The stock hails from the top-ranked Zacks industry (top 28%).
NVR Inc. NVR: This Zacks #1 Ranked company operates in two business segments: homebuilding and mortgage banking. It comes from a top-ranked Zacks industry (top 19%).
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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NVR, Inc. (NVR) : Free Stock Analysis Report
MEDIFAST INC (MED) : Free Stock Analysis Report
Marine Products Corporation (MPX) : Free Stock Analysis Report
Amedisys, Inc. (AMED) : Free Stock Analysis Report
Shoe Carnival, Inc. (SCVL) : Free Stock Analysis Report
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