Profitability is not as straightforward as it can appear to be. Although companies report their net income and revenue every quarter and this is what analysts focus on, profitability is a little more nuanced than that. For a deeper look, it's important to find a company's sources of profitability.
By far the most popular tool for this is the DuPont equation. Engineered at DuPont Corporation, this formula takes a company's return on equity (or net income/equity), and breaks it down into three different components:
= (Net Profit/Equity)
= (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)
= (Net Profit margin)*(Asset turnover)*(Leverage ratio)
Increases in net profit margin and asset turnover are viewed favorably, so their contribution to a rising ROE is also viewed favorably. However increases in the leverage ratio are not a sustainable way to increases profits -- as such, they are not viewed as a "strong" source of profits.
We therefore focus on companies with the following positive 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 with all of these characteristics are experiencing increasing profits due to operations and not to increased use of financial leverage.
Business section: Investing ideas
To illustrate DuPont analysis, we ran it on stocks currently rated as "Overweight" by Barclays Capital (meaning analysts at Barclays believe these stocks will soon outperform).
The 10 stocks below are those that passed DuPont analysis with the highest increases in return on equity.
Do you think these companies have strong sources of profitability?
List sorted by increase in ROE. (Click here to access free, interactive tools to analyze these ideas.)
1. Pioneer Natural Resources
2. CONSOL Energy: Engages in the production of multi-fuel energy and provision of energy services primarily to the electric power generation industry in the United States. Market cap of $8.14B. MRQ Net Profit Margin increased to 11% from 5.59% year-over-year, Sales/Assets increased to 0.13 from 0.12, while Assets/Equity decreased to 3.55 from 3.77. On 11/03/2011, Barclays Capital had an Overweight rating on the stock.
3. Resources Connection: Provides professional services in provides finance, accounting, risk management and internal audit, corporate advisory, strategic communications and restructuring, information management, human capital, supply chain management, actuarial, and legal and regulatory services in support of client-led projects and initiatives. Market cap of $531.05M. MRQ Net Profit Margin increased to 17.47% from 12.61% year-over-year, Sales/Assets increased to 0.33 from 0.29, while Assets/Equity decreased to 1.17 from 1.26. On 02/28/2011, Barclays Capital had an Overweight rating on the stock.
4. SPX: Provides flow technology products, test and measurement products, thermal equipment and services, and industrial products and services worldwide. Market cap of $3.57B. MRQ Net Profit Margin increased to 4.38% from 3.06% year-over-year, Sales/Assets increased to 0.2243 from 0.2179, while Assets/Equity decreased to 2.74 from 2.92. On 10/14/2011, Barclays Capital had an Overweight rating on the stock.
5. WESCO International: Supplies electrical, industrial and communications maintenance, repair, and operating (MRO) products. Market cap of $2.60B. MRQ Net Profit Margin increased to 3.41% from 2.54% year-over-year, Sales/Assets increased to 0.52 from 0.50, while Assets/Equity decreased to 2.39 from 2.41. On 10/14/2011, Barclays Capital had an Overweight rating on the stock.
7. CEVA: Engages in designing and licensing silicon intellectual property (SIP) for the handsets, portable multimedia, and consumer electronics markets. Market cap of $673.66M. MRQ Net Profit Margin increased to 33.20% from 28% year-over-year, Sales/Assets increased to 0.07 from 0.06, while Assets/Equity decreased to 1.09 from 1.11. On 04/13/2011, Barclays Capital had an Overweight rating on the stock.
9. Rockwell Automation
10. Honeywell International
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. Data sourced from Google Finance.
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