Friday, December 08, 2006

Eeny Meeny Miny Moe

Everyone has a framework, approach, or gimmick for selecting individual stocks for investment. Growth, profitability and leverage are the primary factors used to select stocks for Crystal Reports and the Small Cap SEARCH newsletter, both of which target stocks for a long investment strategy. An associate analyst of my firm, Tina Posey recently published a paper on the DuPont Formula used for financial analysis of corporate productivity. The formula is based on accounting figures such as net income, assets and equity.
Posey asked the question, “Whatever Happened to the DuPont Formula?” and found that the formula has lost some of its luster with the ascension of “new economy” business models. She tells us why but provides an example of how the DuPont Formula is being used to select stocks ideas for a small cap fund. The reason the DuPont Formula works so well for stock selection is that its can be boiled down to one figure - return on equity - or disaggregated into a series of equations that reveal volumes about profitability, leverage and asset utilization. The formula is elegant in its simplicity while rich in detail. Posey provides both simple and detailed versions in her paper.
The formula has application after the initial selection process is completed. For example, three of the DuPont formula components are used in all our comparative valuation exercises as a means to put all members of a peer group into perspective against our target company. We also use these same components in a time series to monitor progress and provide an early warning of deteriorating conditions. Time series analysis has some limitations given the dynamic nature of early stage companies, but removing contributions by acquisitions or using pretax figures can still provide a good view on a base business.


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