Hugely profitable companies have a habit of achieving cult-like status in the stock market.For those that catch them early, they can be life-changing. For many of the rest of us, they’re the ones that got away… because they just seemed too expensive at the time.
The appeal of these stocks is often very clear. Profitable companies are those that are likely to have the best chances of protecting themselves through the economic cycle. They often have robust brands and strong customer loyalty. And they are able to operate and grow very efficiently, which means they can drive and compound shareholder returns over the long term.
They’re the kind of stocks you imagine Warren Buffett taking a shine too. They’ve got those elusive moat-like qualities; profits driven by rock-solid competitive advantages that it’s hard to see anyone breaking own.
The price of these stocks, of course, can be extreme. Highly profitable companies are naturally popular in the market and that makes them appear expensive (especially in bull markets). These are the classic hallmarks of what we call at Stockopedia, High Flyers. Strong quality and blistering momentum can be a potent blend over long periods - but it can be a pricey party to attend for anyone arriving late.
A profitability checklist
With this in mind, here’s a quick-fire checklist of possible profitability measures (by no means exhaustive) for use in a strategy looking for financial firepower.
One of the most popular measures of profitability is to look at how much bang a company gets from the pounds it invests in itself. This is called return on capital employed - or ROCE. A high return on capital can be a signpost to stocks with strong and defensible brands and franchises that can be rolled out very profitably.
Another signpost to strong profitability is the percentage that a company keeps from selling its products after all costs have been deducted. This is known as the operating margin. High margins are often a hallmark of companies that can command high prices from their customers and have strong competitive advantages.
Competitive advantage is also something that can be examined by looking at what’s known as return on equity. This is the technical term for comparing a company’s net income to all the cash that investors have put into it. It’s a popular way of comparing the profitability of companies in the…
