Stock analysis doesn’t have to be overly complex, but not to do any analysis is a recipe for disaster. The simplest place to start is by using the Dupont method. You don’t need a CFA, a CPA or an MBA to do it. It is simple and provides a great deal of information about a company’s performance.
Always remember the 80/20 rule. You get 80% of the information with only 20% of the effort. Unfortunately, many want 80% of the information with 0% of the effort. There is no “free lunch”.
The first step entails three ratios. See step one (1) below. First, determine how effective a company is at bringing sales dollars to the bottom line. This is net income divided by the sales and is called return on sales. Next, determine how efficient a company is using their assets to produce sales. This is sales divided by assets and is called asset turnover. Finally, determine how financing affects the return on the business. This is a measure of using borrowed money to enhance returns for the business’s owners (equity owners). This is assets divided by equity and is called the leverage ratio.
The second step requires very simple junior high algebra. You can cross out the sales from return on sales and asset turnover and end up with net income divided by assets or return on assets. This is a measure on how well a company uses assets to produce income. This result is shown in step two (2) below.
In the last step (see 3 below), you cross out the assets from the return on assets and the leverage ratio. This leaves you showing the return on the business for each dollar invested or return on equity.
If you do this for a couple of the company’s fiscal years you can easily see the trend in the company’s performance. That’s it! You don’t have to be overly complex, but you should do this to at least understand what is driving the company’s returns and the direction it is going.
Finally, don’t allow yourself to only use the market to determine whether you should or should not buy the company. The market often is the result of over excitement or under excitement. If the trend of your analysis is up and the market is pushing the price down, you may be looking at a nice pick!
Net Income Sales Assets
1) ---------------- Times ------- Times ---------
Sales Assets Equity
(Return on Sales) times (Assets Turnover) times (Leverage Ratio)
Net Income Assets
2) ---------------- Times - --------
Assets Equity
(Return on Assets) times (Leverage Ratio)
Net Income
3) ----------------
Equity
Return on Equity
