Every Investor Should Know This Stock Tool

Investors like to know how profitable a company is. That's why looking at a stock's return on equity (ROE) is so helpful: It helps distinguish how much in earnings a company generates for each dollar of shareholder capital invested.

Yet simply looking at a stock's ROE doesn't tell us as much as we would like. In order to gain more insight into a company's profitability, you can use DuPont analysis to break down ROE into subcomponents.

What is DuPont analysis?
DuPont analysis breaks down ROE into useful subcomponents to help measure financial performance. In its simplest form, ROE is calculated as net income divided by shareholder equity. (You can find both those numbers on the balance sheet.) However, DuPont analysis thinks of the ROE as a multiple of other financial ratios.

Using the simplest form of the DuPont identity, the formulaic breakdown used in DuPont analysis, ROE results form the net profit margin, multiplied by the asset turnover ratio, multiplied by the equity multiplier ratio:

ROE = (Net Profit Margin)(Asset Turnover Ratio)(Equity Multiplier Ratio)

By breaking the ROE into these three factors, we can get under the hood and inspect the profitability of any industry. Let's see what we can learn when we use DuPont analysis to find the ROEs for pharmaceutical stocks.

Net profit margin
The net profit margin tells us how efficient a company is at turning sales (revenue) into profit (earnings). High net profit margins indicate strong profitability relative to the expenses incurred to achieve that profit. Yet each industry is unique; what one industry considers a high level may seem low for another. As you can see below, drug companies tend to have healthy net profit margins, with 20% being fairly typical in this industry.

Source: Morningstar.com. All numbers in percentages.

From the above table, we see that net profit margins for Merck have gone through the stratosphere in recent years. With margins like that, Merck is putting its competitors to shame. But there are other factors to consider.

Asset turnover ratio
The asset turnover ratio reveals how efficiently a firm employs its assets in generating revenue. A declining asset turnover ratio may indicate sluggish sales, while an increasing ratio could indicate the opposite. Similar to the net profit margin, investors should prefer a higher asset turnover ratio to a lower one. The data below shows the asset turnover ratios of the previously mentioned companies for the last five fiscal years.

Source: Morningstar.com.

Looking at the above table, we see that most of these companies have had flat to slightly decreasing asset turnover ratios for the last five years. However, Novo Nordisk not only had the highest asset turnover ratio last year, but is also the only firm that has been able to increase that figure since 2005.

Equity multiplier
The equity multiplier measures financial leverage; to find it, divide total assets by total stockholder equity. This ratio looks at how a firm uses debt to finance its assets. In contrast to the net profit margin and asset turnover ratio, we want to see a low and decreasing equity multiplier. A high or increasing equity multiplier means that a company is relying more on debt to finance its purchase of assets. While an increase in debt can raise a stock's ROE, it doesn't mean that a company is actually more profitable. Thus, the equity multiplier provides us with clues about how the financing of a firm can artificially inflate its profitability.

Source: Morningstar.com.

The table above displays the equity multiplier ratio for our selected drug manufacturers for the last five fiscal years. From the data, we see that GlaxoSmithKline has seen its equity multiplier increase over the last five years, and it's using more debt to finance its assets than any of its competitors. So we can infer that Glaxo's ROE is benefiting from its use of debt.

The rest of the drug companies have had fairly stable equity multiplier ratios for the last five years, but Novo Nordisk has consistently had the lowest ratio during this time period. As mentioned before, this should perk your interest, since Novo is not pumping up its ROE by incurring debt.

Back to the ROE
Now that we've broken down the ROE ratio using DuPont analysis, we can finally take a look at the trend of drug manufacturers' actual ROEs for the last five years.

Source: Morningstar.com. All numbers in percentages.

While GlaxoSmithKline had the highest ROE of these firms last year, its ROE has decreased over the last five years, despite an increasing equity multiplier, as discussed in the last section. Without increasing its use of debt, Glaxo's ROE would likely have fallen even further. Additionally, Glaxo has recently suffered a major setback; its diabetes drug, Avandia, was pulled off shelves in the U.S. and Europe amid fears of risks to patients' hearts. It's now uncertain whether Glaxo can maintain its current profitability without adding even more debt.

On the other hand, ROE doesn't do Novo Nordisk justice. Its focus on diabetes-care products has allowed Novo to increase its ROE by nearly 10 percentage points since 2005. Its ROE looks sustainable into the future, since the company has become more effective at using its assets to produce revenue without increasing its dependence on debt. With aging populations in both the U.S. and Europe, Novo may be able to continue improving its profitable diabetes-care business in the future.

Be sure to consider more than just the top-line ROE when making your investment decisions. It may help you do a better job of picking a winner from a crowded field.