The order in which companies are filtered based on given metrics does not matter, as eventually, companies passing all metrics will prevail and be deemed to have passed the profitability aspect of an investor’s quantitative analysis. All the values are subjective because they depend on the industry itself, as some are more profitable than others. However, when solely considering the profitability aspect in the context of quantitative analysis, it is better and safer to invest in companies that show higher absolute profitability rather than relative profitability within their own industry. For starters, investors should ask themselves why they would invest in a company that is barely profitable. It must be noted that the suggested metric values are the bare minimum and serve as a guide for quantitative analysis.
The first profitability metric to consider is the return on equity (ROE), which measures how efficiently a company can generate profits from its shareholders’ equity.
1: Return on equity > 15%
From the 613 listed and traded stocks on the SGX, 88 stocks have fulfilled this criterion. An absolute figure of 15% can be considered good, while any figure above 30% can be considered excellent. This is a critical profitability metric because a company’s capital structure is mainly comprised of debt and equity. The company’s debt generally covers its interest payments along with the borrowed capital, as it is a financial obligation, whereas there are no required interest payments for equity holders. Simply put, although a company may become highly profitable, the payment on debt stays the same, but the share of profits among equity holders becomes larger. Hence, the more profitable a company is, the more beneficial it is for shareholders, or equity holders, since the company would be able to generate sufficient profits without relying too much on debt. The return on equity is a great metric to measure this. For investors wanting to scrutinise this ratio further, they can examine how a company’s ROE has progressed over multiple periods, say over the past three to five years.
See also: Why Wall Street has so much riding on mega EA buyout
2: Return on assets > 5%
From the 88 stocks that have an ROE of more than 15%, 79 companies have a return on assets (ROA) of more than 5%. Like ROE, ROA measures how efficiently a company can generate profits from its assets. In other words, if two companies had the same tools, or in this case, assets, a higher ROA would be preferred because that company is using their assets more efficiently or can generate the same amount of profits with fewer assets. Another way to look at it is whether the assets a company owns or has acquired contribute positively to profit generation. For investors looking to delve deeper into this ratio, similar to ROE, this ratio can be analysed over multiple periods. If a company’s profits are growing at a faster rate than its assets, then its ROA would be improving, indicating that the company is becoming more profitable over time. 5% is a good figure for ROA, and anything above 15% is excellent.
3: Gross margins > 30%
See also: What to look for while investing: Financial safety
Margins are a key profitability metric because they measure the business moat of a company, where higher margins imply a wider moat. A wider moat generally means a better competitive advantage over peers. This metric indicates how much of a company’s revenue it can keep after deducting costs. For gross margins, it is the percentage of gross profits over revenue. Gross profit is the revenue minus cost of goods sold; hence, gross margins are the first layer of moat to consider when studying a company’s profitability quantitatively. 30% is regarded as good, while anything above 70% is excellent. Looking at this ratio deeper, higher gross margins imply that a company likely has a competitive advantage, and hence better pricing power since it can manufacture goods at a much lower cost compared to its peers. Out of the 79 companies that have an ROA of more than 5%, less than half, or just 35 companies, have a gross margin of over 30%.
4: Operating margins > 15%
Following gross margins, operating margins are the next margin profitability metric to consider. The difference between gross margins and operating margins is the numerator, where operating profits are used instead of gross profits. From the 35 companies that have gross margins over 30%, 24 companies passed the criterion of having over 15% in operating margins. 15% operating margins are considered strong profitability, while any figure above 20% is regarded as excellent. Operating profits are significant because they show profits that are attributable to the company’s operations, and not other factors such as taxes and interest payments. In other words, operating profits and margins reflect the ability of a company to manage its costs, such as sales and marketing, administrative, and general expenses.
5: Net profit margins > 10%
From the 24 companies that have been filtered so far, 21 companies have a net profit margin of more than 10%. 10% is deemed good, while net profit margins above 20% can be considered excellent. Similar to the difference between operating margins and gross margins, the difference between net profit margins and the other two is the numerator, where it is net profits instead of gross or operating profits. Net profits are essentially the bottom line, as it is commonly known and show how much profit the company can keep after considering all expenses, including taxes and interest. Investors need to be wary of non-recurring, one-off, or extraordinary expenses and transactions that can skew the value of net profits and net profit margins and provide an inaccurate figure for the company’s profitability quantitatively. By considering margins over multiple periods and removing the previously mentioned expenses, investors can more accurately determine the profitability of the company by using net profit margins.
6: Free cash flow margins > 5%
The next element of assessing profitability is the free cash flow margins. The formula for free cash flow margins is the free cash flow divided by revenue. The main difference between net profits and free cash flow is that net profits measure a company’s profitability after all expenses. In contrast, free cash flow measures the cash generated from a company’s operations after deducting capital expenditures. Essentially, this is the cash a company can keep at the end of the day for things such as repaying its debt, dividend distribution, and reinvestment into the business. Free cash flow margins are a vital profitability metric because larger free cash flow margins generally indicate better potential to generate more profits as more cash is available for reinvestment into the business. From the 21 filtered stocks, 15 companies have passed the free cash flow margin filter. 5% can be regarded as good, while anything above 10% can be considered excellent.
For more stories about where money flows, click here for Capital Section
Using these six points, investors should be able to filter and pick out companies that have, at a minimum, good profitability ratios, all the way to exceptional profitability. Table 1 shows the Singapore-listed companies that have fulfilled all the criteria of having good profitability. Depending on how much investors value profitability as an essential part of quantitative analysis, the values of the points can be adjusted. Most importantly, this profitability aspect of quantitative analysis shouldn’t be done in isolation, as there are other factors to consider when looking at a company, such as financial safety. The next part of this series will cover what to look for as a dividend-based investor.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation or solicitation, or expression of views to influence readers to buy or sell stocks, including the stocks mentioned herein. Any personal investments should be made at the investor’s own discretion and/or after consulting licensed investment professionals, at their own risk. The author of this article does not hold or own any stock featured in this article or have a vested interest in it at the time of writing.
