Defensive Value Investing: A 20-week course
“By itself, [earnings per share] says nothing about economic performance. To evaluate that, we must know how much total capital – debt and equity – was needed to produce these earnings.”Warren Buffett
This week we’re going to cover profitability; why it’s important and how to measure it.
But first, if you’re not familiar with the concept of profitability, have a read through the following somewhat unlikely story.
Profitability in competitive markets
Imagine that one day you wake up and decide to run a lemonade stand. You set up a company and invest £1000 as shareholder capital.
The first thing you do with that £1000 is buy a stand, an advertising banner, some cups, lemons and a little sugar. After that you hire an inexpensive teenager to make and sell the lemonade.
You set up your stand in the middle of town and, as it’s the only one in the area, it has a local monopoly on freshly made lemonade. This means you have 100% of the market and can optimise your price in order to maximise profits.
In your first year you make a £10,000 profit, which is a 1000% return on the capital employed within the business (also known as ROCE) which means your business is incredibly profitable.
Unfortunately nothing attracts attention like money, and a lemonade stand with a return on capital employed of 1000% is going to attract a lot of attention. In no time at all you have competition, and lots of it. As you start your second year in the lemonade business, nine new lemonade stands appear on the same street as yours.
Your competitors’ lemonade is just as good as yours, so your market share falls from 100% to just 10% (there are now ten lemonade stands in total and, for the sake of simplicity, you each achieve an equal market share) and your annual revenues and profits decline along with your market share. That’s bad enough, but your problems are not over yet.
Some of the other lemonade stand owners decide to lower their prices in order to win additional market share. As a result of all this competition, the price of a cup of lemonade is eventually driven down to the point where your profits in year two are just £100.
With profits in year two of £100, your return on capital employed (which we’ll assume is still £1000) is now just 10%. With that sort of return you begin to question whether its even worth running a lemonade stand at all. After all, you could just stick your £1000 into an index tracker and, with a bit of luck, you’d get a fairly similar return.
In this scenario there are two ways your business can turn things around:
- Price: Run your business more efficiently and cheaply than everyone else. This will allow you to make a reasonable profit even when prices are low and others are making a loss.
- Quality: If you can sell lemonade which is in some way ‘better’ than everyone else’s lemonade, you may not have to compete with them on price.
This is the creative destruction of capitalism at its best; businesses pushing up quality while pushing down price in order to survive.
If the lemonade stand market becomes so competitive that nobody can make a decent return on capital employed, no new stands will be set up. Entrepreneurs and investors will simply choose to start businesses in other markets where the potential returns are higher.
The same should be true of existing lemonade stand owners as well. If their returns fall significantly below the amount they could get from an equally risky business (perhaps bubble gum stands are more profitable at this point in time), then the economically rational thing to do would be to sell their lemonade stand and invest the proceeds into that higher return business.
And as competitors leave the lemonade market, supply will dry up, prices may rise (due to the reduced competition) and return on capital employed for the remaining businesses might start to head back up again.
The result of this whole process is that most companies, most of the time, return something close to the opportunity cost of their capital, where opportunity cost is the return investors could get from doing something else with their capital that entails a similar degree of risk.
A good measure of opportunity cost for relatively defensive investors is the long-run return on the UK stock market as a whole.
Historically the UK market has produced a total return after inflation of about 5% per year, averaged over the long term, so any company which consistently produces returns on capital employed of about 7% or less (based on a 5% real return plus 2% expected inflation) is generating mediocre returns, at best.
The importance of high profitability
This matters because low profitability companies are often less defensive than their highly profitable peers.
Low profitability companies typically have:
- A harder time growing – Their profits are small relative to their assets (e.g. factories, machinery or vehicles), so it takes much longer to produce enough profits to be able to buy an additional factory (for example).
- Little margin for error – Small profits can be wiped out by relatively small problems, and that can put the dividend at risk.
- Weak competitive advantages – They are susceptible to competitors who can easily find better or cheaper ways of serving their customers.
High profitability companies typically have:
- An easier time growing – Their profits are larger relative to their assets, so they can quickly generate enough profits to build or buy new productive assets. This means they can grow more quickly.
- A wider margin for error – Larger profits can usually absorb problems and mistakes more easily, helping to maintain dividend payments during a downturn.
- Strong competitive advantages – They are less susceptible to competition because their competitive advantages are hard to overcome (I’ll cover competitive advantages in more detail later).
In summary then, profitability is an important indicator of the quality of a company, which is why it’s one of my key metrics.
Measuring return on capital employed
Return on capital employed (ROCE) can be measured in a few different ways. The standard approach is to take returns to be operating profits while capital employed is made up of shareholder equity and total debt (also know as borrowings). In other words, return on capital employed as a percentage is:
ROCE = operating profit / (equity + debt) * 100%
Operating profits are used because it keeps the ratio focused on the operations of the business rather than how those operations are financed. So factors that relate to how the company’s capital are paid for, such as how much the company pays in debt interest, are ignored.
The standard approach is fine, but I prefer to use net profits in the calculation, i.e. profits after debt interest and corporation tax.
Net ROCE = net profit / (equity + debt) * 100%
I do this because net profit takes into account any interest the company pays on its debts, which means highly indebted companies will usually have lower net profits than a debt-free company that was otherwise identical.
That, in turn, means highly indebted companies will have lower net returns on capital employed (all else being equal), which will make them look less attractive. And that’s exactly what I want, because highly indebted companies can be problematic (we’ll cover debt in more detail another week).
I like to measure a company’s results over the long-term, so I don’t measure ROCE just for last year. Instead, I focus on the average over the last ten years. I think this provides a much clearer picture of the sort of returns a company might produce while I own it, which usually covers a period of between one and ten years.
While net return on capital employed is my primary profitability ratio, it isn’t the only one. Another very useful way to look at profitability is by comparing profits to sales.
Measuring net return on sales
Net return on sales, or net profit margin, tells you how much profit a company has squeezed out of each pound paid into the company by customers. It’s calculated as:
Net profit margin = Net profit / revenues * 100%
I use it to identify profits which may be fragile and sensitive to small changes in revenues or expenses. Here’s a quick example:
In reality, most companies can reduce their expenses if their sales fall. However, most thin margin companies do have sensitive profits and in my experience they are usually fragile, weak companies.
And the risk doesn’t only come from declining sales. If expenses are pushed up, perhaps because of increasing prices for fuel and raw materials, the same squeeze on profits can occur if the expense increases cannot be passed onto customers within a relatively short period of time.
Another way to think about profit margins is as a kind of margin of safety. Compared to fat profit margins, thin profit margins provide little margin of safety against the inevitable pressures and mistakes that companies have to deal with.
As with most of my metrics, I measure profit margins over a ten-year period to get a better picture of how a company has performed in good times and bad.
I measure profitability using a combination of ten-year average net return on capital employed and ten-year average net profit margin. That’s quite a mouthful, so I just call the final result a company’s profitability.
Calculating average net return on capital employed
To calculate the average net return on capital employed, you’ll need the following values from the company’s accounts over the last ten years:
- Net profit – This is often called ‘profit for the year’ or similar. You can find it on the income statement.
- Shareholder equity – This is often called ‘total equity’. You can find it on the balance sheet.
- Total borrowings – You can find borrowings on the balance sheet. Most companies have both current and non-current borrowings, and when both are present you’ll need to add them together to get the total.
Once you have those figures, work through the following steps (using a spreadsheet will make this much quicker and easier):
Steps to calculate average net ROCE
The average net ROCE among UK companies is about 10%, so I use the following rule of thumb for profitability.
Rule of thumb
Calculate average net return on sales
You’ll need the following values from the company’s last ten financial results:
- Net profit – You should already have this after calculating net ROCE.
- Revenue – You should already have this after calculating the company’s growth rate and growth quality.
Using those figures, work through the following steps (preferably using a spreadsheet):
Steps to calculate average net profit margin
In my experience, companies with net profit margins below about 5% tend to have many more problems than companies with fatter profit margins, so I use the following rule of thumb:
Rule of thumb
Let’s take that theory and apply it to another example from my recent holdings.
British American Tobacco’s profitability
British American Tobacco (BAT), as the name suggests, is a FTSE 100 company with a long history in the tobacco industry. It owns brands such as Dunhill and Rothmans and is investing in and researching electronic cigarettes as regulation on smoking gets ever tighter.
Calculate net returns on capital employed
To calculate net return on capital employed we’ll need the figures for net profit, shareholder equity and total borrowings, which you can see in Table 3.1 along with the net ROCE value for each year.
|Year||Net profit (£m)||Total equity (£m)||Total borrowings (£m)||Net ROCE|
Table 3.1: British American Tobacco’s net ROCE to 2018
I think the most interesting feature of BAT’s results are 2017 and 2018. In these two years, borrowings jumped up by £30 billion and equity jumped up by about £50 billion. At the same time, return on capital employed has collapsed, from around 15%-20% before 2017 to around 5% after.
The driving force behind these changes was an extremely large acquisition. I’ll cover acquisitions in more detail later, but for now just note the dramatic changes they can have, for better or worse, on a company’s balance sheet and profitability.
Okay, let’s work through the calculation for British American Tobacco’s average net ROCE, step by step:
Calculating British American Tobacco’s average net ROCE
My rule of thumb for average net ROCE is that it’s at least 10%, so that test is just about passed. However, by looking at the returns on a per year basis it’s easy to see that this is a tale of two halves. Before 2017 the company’s ROCE was well above 10% and after 2017 it’s well below 10%.
This is exactly the sort of thing we should look at more closely before investing, and we’ll do that when we look at acquisitions in a later week.
Calculate net profit margins
To calculate net profit margin we’ll need BAT’s net profit and revenue for the last ten years, which you can see in Table 3.2 along with the net margin for each year.
|Year||Net profit (£m)||Revenue (£m)||Net margin|
Table 3.2: British American Tobacco’s net margins to 2018
Here’s the calculation for BAT’s ten-year average net margin:
Calculating British American Tobacco’s average net margin
My minimum standard for average net margins is 5% and British American Tobacco is clearly above that level. In fact, margins of 25% are above average so it’s quite likely that this company has some reasonably strong competitive advantages (which we’ll also look at in a later week).
Next week we’ll look at how the balance between equity capital and debt capital can affect a company’s prospects.
For now though, here’s a summary of the profitability rules of thumb:
Rules of thumb for high profitability