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.
= (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.
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
2. Dow Chemical
8. Northrop Grumman
9. Archer Daniels Midland
10. Wisconsin Energy
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.