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Stock Investing: Evaluating a Company’s Profitability

Companies with economic moats will consistently post higher profitability than the industry. Therefore, by evaluating a company’s profitability, you will know whether a company has economic moats or not.

Free Cash Flow

Free cash flow is cash leftover after reinvesting into the business to keep the business growing. You can find a company’s free cash flow by looking at the statement of cash flows which you can find in the annual reports. Simply use “cash flows from operations” minus “capital expenditure”.

Free Cash Flow: = Cash Flows from Operating Activities - Capital Expenditure

*Note: Capital expenditure is also know as Property, Plant and Equipment, which are assets needed to sustain or grow the business.

Next, divide free cash flow by sales. This tells you what percentage of sales the company is able to convert into excess cash.

Free Cash Flow Margin = [ Free cash flow / Sales ] x 100%

If a company’s free cash flow is higher than 5% of sales, then you have found yourself a cash generating company. Strong free cash flow is a sign of economic moat.

Example: Free Cash Flow Margin

Find the Free Cash Flow Margin for the following company.

Income Statement
Sales or Revenues	$120,000
Statement of Cash Flows
Cash Flow from Operating Activities	$15,000
Property, Plant & Equipment	($8,000)

Free cash flow = $15,000 - $8,000 = $7,000
Free cash flow margin = $7,000 / $120,000 x 100% = 5.8%

Net Margin

Net margin is simply Net Profit divide by Sales. It tells us how effective the company is in turning every dollar of sales into profits. In general, companies with a net margin of 15% or higher are on the right track.

Net Margin = [ Net Profit / Sales ] x 100%

Example: Net Margin

Find the Net Margin for the following company.

Income Statement
Sales or Revenues	$120,000
Net Profit or Net Income	$ 20,000

Net Margin = $20,000 / $120,000 x 100% = 17%

Return on Equity (ROE)

ROE is net profit as a percentage of shareholders’ equity. Companies that can consistently earn ROE of 15% are generating solid returns and these companies are likely to have economic moats.

ROE = [ Net Profit / Shareholders' Equity ] x 100%

Example: Return on Equity (ROE)

Find the ROE for the following company.

Income Statement
Net Profit or Net Income	$20,000
Balance Sheet
Total Shareholders' Equity	$180,000

ROE = $20,000 / $180,000 x 100% = 11%

Return on Assets (ROA)

ROA is net profit as a percentage of the company’s assets. It measures how efficient the company is in converting its assets info profits. If a company can consistently earn ROA of 7% then it may have an economic moat.

ROA = [ Net Profit / Total Assets ] x 100%

Example: Return on Assets (ROA)

Find the ROA for the following company.

Income Statement
Net Profit or Net Income	$20,000
Balance Sheet
Total Assets	$250,000

ROA = $20,000 / $250,000 x 100% = 8%

Summary

Look up at least 5 years of financials when so you get a picture of the profitability trend of the company. When you have found a company that consistently post high profitability year after year, then you have found a potential great investment.

Next, you will need to dig deeper to identify the economic moats, get to know the management, understand the industry and business, scrutinize the financials and finally value the company (or stock).

Previous: Stock Investing: Find Economic Moats.