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 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 five stocks that made it through the screen:
Lifeway Foods: This Zacks Rank #1 company produces Kefir, a drinkable product similar to but distinct from yogurt, in several flavors sold under the name Lifeway’s Kefir.
The average earnings surprise of LWAY for the past four quarters is 141.67%.
EMCOR Group: The company is one of the leading providers of mechanical and electrical construction, industrial and energy infrastructure, as well as building services for a diverse range of businesses. It has a Zacks Rank #2.
The average earnings surprise of EME for the past four quarters is 17.24%.
Super Micro Computer: The Zacks Rank #1 company designs, develops, manufactures and sells energy-efficient, application optimized server solutions based on the x86 architecture.
The average earnings surprise of SMCI for the past four quarters is 3.26%.
Group 1 Automotive: The Zacks Rank #2 company is one of the leading automotive retailers in the world, with operations primarily located in the United States and the UK.
The average earnings surprise of GPI for the past four quarters is 7.96%.
PBF Energy: The Zacks Rank #2 company is a leading refiner of crude. Through five oil refineries and associated infrastructure in the United States, the company provides end products that comprise heating oil, transportation fuels, lubricants and many related products.
The average earnings surprise of PBF for the past four quarters is 8.34%.
EMCOR Group, Inc. (EME): Free Stock Analysis Report
This article originally appeared on Zacks
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