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For companies that appear undervalued relative to price multiples, it is helpful to check if the market is in fact underestimating the company by running a profitability analysis.

Improvements in the sources of profitability can further indicate that the company is being underpriced.

We performed a DuPont analysis of return on equity for stocks undervalued to earnings growth (with PEG below 1). From this analysis, we found 9 companies that passed all requirements for positive sources of change in return on equity year-over-year.

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the top six stocks mentioned below. Analyst ratings sourced from Zacks Investment Research.

We broke the ROE equation into three parts:

ROE

= (Net Profit/Equity)

= (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)

= (Net Profit margin)*(Asset turnover)*(Leverage ratio)

All of the stocks mentioned below have seen rising ROE values for the recent quarter, year-over-year. Then we wanted to analyze the sources of these returns, so we narrowed down the original universe to only focus on companies with the following characteristics:

  • Decreasing leverage, i.e. decreasing Asset/Equity ratio
  • Improving asset use efficiency (i.e. declining Sales/Assets ratio) and improving net profit margin (i.e. declining Net Income/Sales ratio)

Companies passing all requirements are thus experiencing increasing profits due to operations and not to increased use of leverage.

Do you think the market is pricing these stocks fairly? Use this list as a starting-off point for your own analysis.

List sorted by increase in quarterly ROE year-over-year.

1. Caterpillar Inc. (NYSE:CAT): Farm & Construction Machinery Industry. Market cap of $61.86B. PEG at 0.81. Return on Equity increased from 2.61% to 9.95%. When analyzing the sources of return, Net Profit Margin increased from 2.83% to 9.46%. Sales/Assets increased from 0.14 to 0.20, while Assets/Equity decreased from 6.58 to 5.26 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). The stock has gained 48.81% over the last year.

2. Vale S.A. (NYSE:VALE): Steel & Iron Industry. Market cap of $155.87B. PEG at 0.45. Return on Equity increased from 2.61% to 8.99%. When analyzing the sources of return, Net Profit Margin increased from 24.29% to 51.66%. Sales/Assets increased from 0.06 to 0.10, while Assets/Equity decreased from 1.79 to 1.74 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). The stock has gained 14.14% over the last year.

3. KLA-Tencor Corporation (NASDAQ:KLAC): Semiconductor Equipment & Materials Industry. Market cap of $6.40B. PEG at 0.63. Return on Equity increased from 2.65% to 7.93%. When analyzing the sources of return, Net Profit Margin increased from 11.92% to 25.15%. Sales/Assets increased from 0.13 to 0.19, while Assets/Equity decreased from 1.71 to 1.66 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). The stock has performed poorly over the last month, losing 11.04%.

4. General Motors Company (NYSE:GM): Auto Manufacturers Industry. Market cap of $45.26B. PEG at 0.45. Return on Equity increased from 3.63% to 8.88%. When analyzing the sources of return, Net Profit Margin increased from 3.39% to 9.30%. Sales/Assets increased from 0.23 to 0.25, while Assets/Equity decreased from 4.65 to 3.82 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11).

5. Atmel Corporation (NASDAQ:ATML): Semiconductor Industry. Market cap of $5.75B. PEG at 0.71. Return on Equity increased from 2.17% to 7.06%. When analyzing the sources of return, Net Profit Margin increased from 4.77% to 16.16%. Sales/Assets increased from 0.25 to 0.28, while Assets/Equity decreased from 1.82 to 1.56 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). It's been a rough couple of days for the stock, losing 7.78% over the last week.

6. Alcoa, Inc. (NYSE:AA): Aluminum Industry. Market cap of $15.66B. PEG at 0.59. Return on Equity increased from -1.60% to 2.12%. When analyzing the sources of return, Net Profit Margin increased from -4.11% to 5.17%. Sales/Assets increased from 0.13 to 0.15, while Assets/Equity decreased from 2.99 to 2.73 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). This is a risky stock that is significantly more volatile than the overall market (beta = 2.06). The stock has performed poorly over the last month, losing 11.8%.

7. Las Vegas Sands Corp. (NYSE:LVS): Resorts & Casinos Industry. Market cap of $27.85B. PEG at 0.74. Return on Equity increased from 0.30% to 3.89%. When analyzing the sources of return, Net Profit Margin increased from 1.32% to 13.70%. Sales/Assets increased from 0.07 to 0.10, while Assets/Equity decreased from 3.20 to 2.84 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). The stock is currently stuck in a downtrend, trading 6% below its SMA20, 11.25% below its SMA50, and 12.01% below its SMA200. The stock has gained 42.75% over the last year.

8. Siemens AG (SI): Telecom Services Industry. Market cap of $119.97B. PEG at 0.71. Return on Equity increased from 5.25% to 8.84%. When analyzing the sources of return, Net Profit Margin increased from 8.95% to 15.76%. Sales/Assets increased from 0.17 to 0.17, while Assets/Equity decreased from 3.45 to 3.30 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). The stock has gained 41.49% over the last year.

9. Arch Coal Inc. (NYSE:ACI): Industrial Metals & Minerals Industry. Market cap of $5.29B. PEG at 0.42. Return on Equity increased from -0.09% to 2.45%. When analyzing the sources of return, Net Profit Margin increased from -0.25% to 6.37%. Sales/Assets increased from 0.15 to 0.18, while Assets/Equity decreased from 2.29 to 2.14 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). The stock is currently stuck in a downtrend, trading 9.23% below its SMA20, 17.87% below its SMA50, and 18.56% below its SMA200. The stock has performed poorly over the last month, losing 14.41%.

*Accounting data sourced from Google Finance, all other data sourced from Finviz.

Source: Top 9 Most Undervalued Stocks With Healthy Profits