The concept of corporate earnings seems pretty straightforward. Sales are reduced by the costs of goods sold to determine a company’s gross margin and to see how profitable its product line is. From that number all other general and administrative expenses are deducted to determine the company’s operating profit (or margin) to see how efficient the enterprise it is. From there, things get a little more nuanced. And, the ultimate journey to “net income” can travel different paths.
This is why looking at net income alone doesn’t always reveal worthwhile investments. Net income may not actually be the best measure of corporate profitability because it can include a host of one-time items that have nothing to do with a company’s core business. For example, things like gains or losses on divestitures, acquisitions, or foreign currency transactions, as well as the effect of acceleration or deceleration of various accruals can end up getting recognized in between operating margin and net income. What’s more, a company’s capital structure and the way in which it uses its balance sheet to finance (both current and long-term) operations can affect net income.
Knowing there are limitations on net income figure, what other profitability measures might you look to assess profitability? For that answer, I turn to the published strategies written by or about great investors.
Return on Equity
Investment management gurus, David Dreman, author of the book Contrarian Investment Strategies, and Warren Buffett, the legendary chairman of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), both regard a company’s Return on Equity (ROE) as a key component of their investment criteria. Dreman would screen the 1,500 largest capitalized firms to look for companies which had an ROE greater than the top 33% of the universe. At the current time, that threshold is around 18.5%. Buffett regularly searches for those that have an ROE of at least 15%, but the twist with the Buffett model is it wants to see that 15% over the past decade and also the last three years. By looking at a long-term stream of profitability, the model seeks to identify those companies with a competitive and protective moat around their businesses and profits.
Return on Equity is the proportion of net income to shareholders’ equity. Shareholders’ equity is the (net) difference between a company’s total assets and liabilities. So, to a certain degree, ROE could be argued to be a measure of how much return a company’s net assets produce for its shareholders. But, that definition is just a little subjective since the company’s overall capital structure will affect the balance of shareholders’ equity.
Using more leverage can create a higher ROE. That’s why both Dreman and Buffett use other measures to confirm overall profitability and fiscal soundness. Dreman also looked closely at pre-tax profit margins in his analysis while Warren Buffett looks deeper at the firm’s capital structure. So, did Joel Greenblatt.
Return on Capital
The calculation to determine Return on Capital (ROC) is slightly different than the one used to produce ROE. The starting point is earnings before interest and taxes (EBIT) and dividing that by the firm's total capital, which includes both debt and equity. The result is the return percentage generated by all of the company’s operations, including the types of one-time items mentioned above. A benefit of using ROC to evaluate a company’s profitability is that it tells you how effective the firm is at creating a profit with the money entrusted to it by both debt and equity investors.
When considering Return on Capital, Warren Buffett is looking for a history of 12% over the past decade and also over the past three years. Joel Greenblatt, author of the book, The Little Book That Beats The Market, and managing partner of hedge fund, Gotham Capital, uses a slightly modified version of ROC. But he wasn’t so much looking for a target percentage such as 12%. Rather, he would use return on capital to compare the relative attractiveness of different companies in an overall ranking system.
The algorithms run on Validea track the investment styles of various investment gurus and can be used to screen for stocks based on their strategies. Using the profitability measures discussed above, we can mine for stocks that meet the criteria of great investors and have strong profitability characteristics.
In the screen below, I have used Validea's Guru Stock Screener to look for stocks that pass at least two of the guru models I run with an 80% score or higher and also pass short- and long-term (10-year) ROE (minimum 15%) and ROC (minimum 12%) criteria. The list below of 15 names, which should be used as a starting point for more investigation, includes names you might suspect, including Apple (AAPL), Northrop Grumman (NOC), Monster Beverage (MNST) and Tractor Supply (TSCO), but also has some surprises, including William-Sonoma (WSM), Biogen (BIIB) and British American Tobacco (BTI).
Disclosure: I am/we are long AAPL, MNST, TSCO,BIIB, BTI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.