Why investing in highly profitable companies is a good idea
“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, both 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, as the company’s only shareholder, you invest £1000. This is known as shareholder capital or shareholder equity.
The first thing you do with that £1000 is buy a stand, an advertising banner, some cups, lemons, sugar and other necessary bits and pieces. Then 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 main strategies your business can employ to turn things around:
- Low cost: 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.
- Differentiation: If you can sell lemonade which is in some way better unique compared to your competitors’ lemonade, then you may not have to compete with them on price.
This is the creative destruction of capitalism at its best; businesses providing better products or services at lower prices in order to survive and hopefully thrive.
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
Profitability matters because highly profitable companies often produce higher returns with less risk than their low profitability peers.
For example, low profitability companies typically have:
- A harder time growing – Their profits are small relative to their capital assets (e.g. factories, machinery or vehicles), so it takes 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.
While high profitability companies typically have:
- An easier time growing – Their profits are larger relative to their capital assets, so they can reinvest more earnings to build or buy new capital assets at a much faster rate. These new capital assets can then be used to grow revenues and earnings 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 capital (shareholder equity) and debt capital (total 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 = post-tax profit / (equity + debt) * 100%
I do this because post-tax 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 tend to have lower net returns on capital employed (net ROCE), 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 in a later week).
Taking account of lease liabilities
The standard ROCE ratio (or even net ROCE) is very useful, but it can be improved by taking account of leased capital as well as shareholder capital and debt capital. Leased capital comes mostly in the form of operating lease liabilities, where the leases cover things like retail stores, factories, vehicles and other expensive capital (i.e. long-term) assets.
Companies lease capital assets because it’s more flexible and less risky than purchasing the asset outright. For example, let’s say you want to start your own retail business. You go to a bank, take out a 20-year interest-only loan for £1 million and use it to buy a large store on your local high street. After five years of hard work the business isn’t doing well and you think it’s the location. You want to move to a nearby high street, so you decide to sell. Unfortunately the economic environment is weak and the best offer you get for your store is £700,000.
You now have a dilemma. You either stay where you are in a sub-optimal location, or you take a £300,000 capital loss on the chin. Either way, your business is being affected to an enormous degree by commercial property price movements, and that’s a bad idea because your core skill is retail and not property speculation.
So in contrast to buying, leasing gives companies the right to use expensive capital assets (such as property, machinery or other equipment) for a fixed period of time in exchange for a regular (and typically) fixed rental payment. If the value of the asset goes up or down, it doesn’t matter. All the leasee has to worry about is making those regular payments.
So leasing removes much of the risk associated with asset ownership, but there are downsides as well because lease liabilities are essentially the same as debt liabilities.
To explain what I mean, here’s another example. Let’s say you lease a retail store for a fixed period of five years, but instead of paying rent monthly, you decide to borrow enough money from the bank so you can pay all the rent up front. You’ll still have the same right to use that property for five years, but you’re now obliged to make monthly payments to the bank rather than the landlord.
In terms of financial risk and cash flows it makes little difference whether you’re obliged to pay a bank or a landlord, so thinking of lease liabilities as a form of debt really does make a lot of sense.
Finding lease liabilities in the accounts
One reason the standard ROCE ratio doesn’t include leased capital is that historically, lease liabilities haven’t been recorded on the balance sheet.
That’s odd, because the balance sheet is where you’ll find shareholder capital (net assets or shareholder equity) and debt capital (current and non-current borrowings), along with most other financial assets and liabilities.
Historically, operating leases were seen as an operating expense, with rents showing up on the income statement as an expense and with no mention being made of the obligation (the liability) to pay that rent in future years.
However, this is all changing with a new accounting standard which goes by the name of IFRS 16: Leases. This will bring operating lease liabilities onto the balance sheet, with the future lease commitment recorded as a liability. This will be balanced on the asset side by a “right of use” asset.
This liability is starting to appear on the 2019 and 2020 balance sheets of many companies, which makes lease-adjusting ROCE that much easier. The resulting ratio is called net return on lease-adjusted capital employed (net ROLACE).
Net ROLACE = post-tax profit / (equity + borrowings + lease liabilities) * 100%
Measuring long-term profitability
I like to measure a company’s results over the long-term, so I don’t measure net ROLACE 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.
This presents a small problem because lease liabilities weren’t recorded on the balance sheet before 2020. To find lease liabilities in earlier reports you’ll need to search each report for the term “operating lease”.
In most cases this will lead you to an entry in the notes to the accounts (at the back of the annual report) which typically shows outstanding minimum lease liabilities extending one year, two to five years, and more than five years into the future, as well as their combined total. I simply take this total minimum lease liability figure and use that to calculate ROLACE.
Rather than calling my main profitability metric the ten-year average net return on lease-adjusted capital employed, I just call it Profitability.
To calculate Profitability, you’ll need the following values from the company’s accounts over the last ten years:
- Post-tax profit– You can find this near the bottom of the income statement.
- Equity – This is often called ‘total equity’. You can find it on the balance sheet.
- 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.
- Lease liabilities – You’ll have to search through the annual reports for “lease liab” or “operating lease”. For 2019 and beyond these may visible be on the balance sheet, otherwise they’ll be in the notes at the back of the report.
Once you have those figures, work through the following steps (using a spreadsheet will make this much quicker and easier):
Steps to calculate Profitability
The average net return on lease-adjusted capital employed among dividend paying UK companies is about 10%, so I use the following rule of thumb for Profitability.
Rule of thumb
So that’s return on capital employed. I think it’s an incredibly important ratio and it’s my primary profitability ratio, but it isn’t the only one. I think another very useful way to look at profitability is by comparing earnings to sales.
Measuring return on sales
Return on sales (ROS), 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:
Return on sales = Post-tax profit / revenue * 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.
Calculate average return on sales
You’ll need the following values from the company’s last ten annual reports:
- Post-tax profit – You should already have this after calculating Profitability.
- 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 return on sales (ROS)
In my experience, companies with an average return on sales below about 5% tend to have more problems than companies with fatter profit margins. This isn’t always true, but it’s generally true, so unless I can see a good reason to invest in a thin margin company, I will usually apply the following rule of thumb:
Rule of thumb
Let’s take these metrics and apply them to another real-world example from my portfolio.
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.
To calculate Profitability we’ll need the figures for net earnings, shareholder equity, total borrowings and lease liabilities, which you can see in Table 3.1 along with the net ROLACE value for each year.
|Year||Post-tax Profit (£m)||Equity (£m)||Borrowings (£m)||Leases (£m)||Net ROLACE|
Table 3.1: British American Tobacco’s net ROLACE 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 lease-adjusted capital employed 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 a later week, but for now just note the dramatic changes they can have, for better or worse, on a company’s balance sheet and profitability.
Here’s the calculation for British American Tobacco’s Profitability, step by step:
Calculating British American Tobacco’s Profitability
My rule of thumb for Profitability is that it should be at least 10%, so BAT just about passes that test. 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 ROLACE was well above 10% and after 2017 it’s well below 10%.
This is exactly the kind of odd result we should look at more closely before investing, and we’ll do that when we look at acquisitions in a later week.
Calculate return on sales
To calculate return on sales we’ll need BAT’s net earnings and revenue for the last ten years, which you can see in Table 3.2 along with the return on sales for each year.
|Year||Post-tax profit (£m)||Revenue (£m)||Return on sales|
Table 3.2: British American Tobacco’s return on sales to 2018
Here’s the calculation for BAT’s ten-year average return on sales:
Calculate British American Tobacco’s average return on sales
My minimum standard for average return on sales is 5% and British American Tobacco is clearly above that level. In fact, margins of 25% are a long way above average, so it’s likely that this company has reasonably strong competitive advantages of one kind or another (competitive advantages will be covered 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 my profitability rules of thumb:
Rules of thumb for profitability