There are tens if not hundreds of different ways to look at a company's profitability. Measures such as gross margin, return on assets, and net income all measure different things yet fall under the umbrella of "profitability." Because of the massive amount of options, it's important to know what to look for when studying a company's operational results.
One of analysts' favorite profitability tools is DuPont analysis -- it's a way to look at changes in return on equity (ROE) profitability (i.e., net income/equity) by attributing those changes to certain sources. Some of the sources are more sustainable than others, thereby giving an analysis of strength in increasing profitability.
The DuPont Equation
ROE can be broken up into three components: net margin, asset turnover (a measure of efficiency), and financial leverage (a measure of debt). Increases in the first two are preferable and sustainable, while increases in financial leverage are not.
ROE
= (Net Profit/Equity)
= (Net Profit/Sales)*(Sales/Assets)*(Assets/Equity)
= (Net Profit Margin)*(Asset Turnover)*(Leverage Ratio)
From this breakdown, we can focus on companies with the following characteristics: Increasing ROE along with:
- Decreasing leverage, i.e., decreasing asset/equity ratio
- Improving asset use efficiency (i.e., increasing sales/assets ratio) and improving net profit margin (i.e., increasing net income/sales ratio)
Companies passing all requirements are thus experiencing increasing profits due to operations and not to increased use of leverage.
Investing ideas
To illustrate this tool, we ran DuPont analysis on stocks of the S&P 500 paying dividend yields above 2% and sustainable payout ratios below 50% (payout ratio being the percentage of earnings paid out as dividends).
Do you think these stocks pay more reliable dividends because of their strong profitability trends?
List sorted by increase in ROE. (Click here to access free, interactive tools to analyze these ideas.)
1. General Electric (NYSE: GE ) : Operates as a technology, service, and finance company worldwide. Market cap of $173.74B. Dividend yield at 3.66%, payout ratio at 47.42%. MRQ Net Profit Margin increased to 9.12% from 5.81% year-over-year, Sales/Assets increased to 0.0479 from 0.0466, while Assets/Equity decreased to 5.93 from 6.57.
2. Dow Chemical (NYSE: DOW ) : Manufactures and supplies products used as raw materials in the production of customer products and services worldwide. Market cap of $33.34B. Dividend yield at 3.54%, payout ratio at 32.23%. MRQ Net Profit Margin increased to 5.96% from 4.64% year-over-year, Sales/Assets increased to 0.23 from 0.19, while Assets/Equity decreased to 2.77 from 3.01.
3. Snap-on (NYSE: SNA ) : Manufactures and markets tools, diagnostics, equipment, software, and service solutions for professional users in the United States, the United Kingdom, Canada, Germany, Japan, France, Australia, Spain, the Netherlands, Italy, China, and Sweden. Market cap of $3.20B. Dividend yield at 2.43%, payout ratio at 22.65%. MRQ Net Profit Margin increased to 9.72% from 7.12% year-over-year, Sales/Assets increased to 0.1921 from 0.1889, while Assets/Equity decreased to 2.33 from 2.50.
4. Honeywell (NYSE: HON ) : Operates as a diversified technology and manufacturing company worldwide. Market cap of $41.74B. Dividend yield at 2.76%, payout ratio at 40.04%. MRQ Net Profit Margin increased to 9.27% from 7.35% year-over-year, Sales/Assets increased to 0.24 from 0.21, while Assets/Equity decreased to 3.38 from 3.69.
5. Eaton (NYSE: ETN ) : Operates as a power management company worldwide. Market cap of $15.13B. Dividend yield at 3.00%, payout ratio at 35.17%. MRQ Net Profit Margin increased to 8.85% from 7.50% year-over-year, Sales/Assets increased to 0.23 from 0.21, while Assets/Equity decreased to 2.28 from 2.36.
6. Staples (Nasdaq: SPLS ) : Operates as an office products company. Market cap of $10.56B. Dividend yield at 2.69%, payout ratio at 36.27%. MRQ Net Profit Margin increased to 3.03% from 2.34% year-over-year, Sales/Assets increased to 0.43 from 0.42, while Assets/Equity decreased to 1.92 from 2.05.
7. Xerox (NYSE: XRX ) : Engages in the development, manufacture, marketing, service, and finance of document equipment, software, solutions, and services worldwide. Market cap of $11.72B. Dividend yield at 2.01%, payout ratio at 22.77%. MRQ Net Profit Margin increased to 5.73% from 4.61% year-over-year, Sales/Assets increased to 0.1828 from 0.1760, while Assets/Equity decreased to 2.33 from 2.52.
8. Northrop Grumman (NYSE: NOC ) : Provides products, services, and solutions in aerospace, electronics, information systems, shipbuilding, and technical service sectors. Market cap of $15.22B. Dividend yield at 3.43%, payout ratio at 28.77%. MRQ Net Profit Margin increased to 7.86% from 7.03% year-over-year, Sales/Assets increased to 0.26 from 0.23, while Assets/Equity decreased to 2.10 from 2.29
9. Archer Daniels Midland (NYSE: ADM ) : Archer Daniels Midland Company procures, transports, stores, processes, and merchandises agricultural commodities and products in the United States and internationally. Market cap of $19.63B. Dividend yield at 2.38%, payout ratio at 19.18%. MRQ Net Profit Margin increased to 2.10% from 2.05% year-over-year, Sales/Assets increased to 0.74 from 0.65, while Assets/Equity decreased to 1.62 from 1.68.
10. Wisconsin Energy (NYSE: WEC ) : Engages in the generation, distribution, and sale of electric energy and steam. Market cap of $7.61B. Dividend yield at 3.16%, payout ratio at 43.57%. MRQ Net Profit Margin increased to 12.33% from 11.53% year-over-year, Sales/Assets increased to 0.0795 from 0.0765, while Assets/Equity decreased to 3.34 from 3.38.
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.
Kapitall's Alexander Crawford does not own any of the shares mentioned above. Accounting data sourced from Google Finance, all other data sourced from Finviz. Data sourced from November 7.
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