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:
ROE
= (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 ten 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?
Use the Turbo Chart to Compare the Performance of the First Two Companies in the List to the S&P 500:
List sorted by increase in ROE.
1. Pioneer Natural Resources Co. (PXD, Earnings, Analysts, Financials): Engages in the exploration and production of oil and gas in the United States, South Africa, and Tunisia. Market cap of $12.37B. MRQ Net Profit Margin increased to 34.07% from 19.12% year-over-year, Sales/Assets increased to 0.09 from 0.06, while Assets/Equity decreased to 2.17 from 2.30. On 03/29/2011, Barclays Capital had an Overweight rating on the stock.
2. CONSOL Energy Inc. (CNX, Earnings, Analysts, Financials): 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 11.0% 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 Inc. (RECN, Earnings, Analysts, Financials): 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 Corporation (SPW, Earnings, Analysts, Financials): 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 Inc. (WCC, Earnings, Analysts, Financials): 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.
6. LSI Corporation (LSI, Earnings, Analysts, Financials): Designs, develops, and markets storage and networking semiconductors and storage systems worldwide. Market cap of $3.99B. MRQ Net Profit Margin increased to 5.36% from 5.17% year-over-year, Sales/Assets increased to 0.24 from 0.18, while Assets/Equity decreased to 1.78 from 1.80. On 01/03/2012, Barclays Capital had an Overweight rating on the stock.
7. CEVA Inc. (CEVA, Earnings, Analysts, Financials): 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 28.0% 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.
8. Cummins Inc. (CMI, Earnings, Analysts, Financials): Designs, manufactures, distributes, and services diesel and natural gas engines, electric power generation systems, and engine-related component products worldwide. Market cap of $21.01B. MRQ Net Profit Margin increased to 9.77% from 8.32% year-over-year, Sales/Assets increased to 0.41 from 0.34, while Assets/Equity decreased to 2.18 from 2.35. On 09/28/2011, Barclays Capital had an Overweight rating on the stock.
9. Rockwell Automation Inc. (ROK, Earnings, Analysts, Financials): Provides industrial automation power, control, and information solutions. Market cap of $11.31B. MRQ Net Profit Margin increased to 12.20% from 9.67% year-over-year, Sales/Assets increased to 0.31 from 0.29, while Assets/Equity decreased to 3.02 from 3.25. On 10/14/2011, Barclays Capital had an Overweight rating on the stock.
10. Honeywell International Inc. (HON, Earnings, Analysts, Financials): Operates as a diversified technology and manufacturing company worldwide. Market cap of $44.95B. 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. On 10/14/2011, Barclays Capital had an Overweight rating on the stock.
(Written by Alexander Crawford. Data sourced from Google Finance.)
Use Kapitall’s Tools: Looking for ways to analyze this list?
Use this article snapshot as a launch pad (click here for help): Simply click on the links, and use Kapitall’s tab navigation to browse through the data…
Analyze These Ideas: Getting Started
Dig Deeper: Access Company Snapshots, Charts, Filings
- Pioneer Natural Resources Co. (PXD, Chart, Download SEC Filings)
- CONSOL Energy Inc. (CNX, Chart, Download SEC Filings)
- Resources Connection Inc. (RECN, Chart, Download SEC Filings)
- SPX Corporation (SPW, Chart, Download SEC Filings)
- WESCO International Inc. (WCC, Chart, Download SEC Filings)
- LSI Corporation (LSI, Chart, Download SEC Filings)
- CEVA Inc. (CEVA, Chart, Download SEC Filings)
- Cummins Inc. (CMI, Chart, Download SEC Filings)
- Rockwell Automation Inc. (ROK, Chart, Download SEC Filings)
- Honeywell International Inc. (HON, Chart, Download SEC Filings)
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