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 get fooled by picking stocks based on this number. Thus, taking a step beyond the basic ROE and analyzing it at an advanced level or applying the DuPont technique seems to be an intriguing idea.
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?
The DuPont analysis allows investors to assess the elements that play a dominant role in any change in ROE. It can help investors to separate companies having 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.
In fact, it also focuses on the company’s leverage status. A lofty ROE could be due to the overuse of debt. If this is the case, the strength of a company can be uncertain if it has a high debt load.
So, an investor confined solely to a ROE perspective may be confused if he or she has to judge between two stocks of equal ratio. This is where DuPont analysis gets the upper hand while finding out 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 nine stocks that made it through the screen:
Ross Stores Inc. ROST: This Zacks Rank #2 company operates Ross Dress for Less (Ross), the largest off-price apparel and home fashion chain in the United States, the District of Columbia and Guam. The stock comes from a top-ranked Zacks industry (top 5%).
Shoe Carnival Inc. SCVL: The company is one of the nation's largest family footwear retailers. The stock carries a Zacks Rank #2 and belongs to a top-ranked Zacks industry (top 40%).
Stitch Fix Inc. SFIX: The company provides an online subscription and personal shopping platform. Its stock hails from a top-ranked Zacks industry (top 40%) and has a Zacks Rank #2.
Amedisys Inc. AMED: The company is a leading provider of healthcare in home with a vision of becoming the premiere solution for patients. The stock carries a Zacks Rank #1 and comes from a top-ranked Zacks industry (top 30%).
NVR Inc. NVR: This company operates in two business segments: homebuilding and mortgage banking. The homebuilding unit sells and constructs homes under the Ryan Homes, NVHomes and Heartland Homes brands. It has a Zacks Rank #1 and belongs to a top-ranked Zacks industry (top 16%).