[List of Profitable Businesses] When we search for the most profitable share, what we are actually looking for? We are searching for stocks of those companies that have a very profitable underlying business. How one can identify such shares?
Our search can be based on the following two approaches:
- First: It’s based on historical price appreciation. We can check the price trend. If the price growth is fast enough, the company can be assumed as profitable. For example, the market price of TCS has grown by 2.4 times in the last 5 years, hence is profitable. We are assuming that all stocks that have seen good price growth have a profitable business. But judging the profitability based only on price trends is like incomplete work.
- Second: It is based on a profitability analysis of the underlying business. This article will focus on identifying the most profitable share based on this approach. We’ll use the profitability ratios of companies and compare them with their respective industry benchmarks.
List of Most Profitable Shares
(Updated on 28-JAN-2023)
|SL||Name||Industry||ROE (Ind)||ROE||ROCE (Ind)||ROCE||OPM (Ind)||OPM||GMR Score|
|4||ISMTLTD:||Steel Tubes & Pipes||12.55||83.98||17.36||68.02||8.48||20.16||79.30|
|8||Balmer Law:||Misc. Fin.services||14.78||43.53||17.56||44.60||48.51||0.00||70.50|
Profitable Business – The Concept
What is a profitable business? The answer must be simple, right? High-profit margin companies must be the choice. But this simplistic definition of profitability may not be accurate. In our search, we must also focus on the following:
- Industry Focus: If we’ll focus only on high-margin companies, we’ll miss out on other good companies. Why? Because all companies do not operate at high margins. The reason for their low margins could be the inherent characteristic of the industry within which they operate. Our target is to find the most profitable share within each industry.
- Degree of Profitability: Companies that display lower margins may sometime prove better than other high-margin companies. How? Because what matters more is the degree of profitability. For example, in an industry whose average profitability is 6%, a company operates at 15% levels. It is better than a 20% margin company, with an industry average of 18%. A high degree of profitability is symbolic of the company’s economic moat (competitiveness).
What is the logic? It takes a lot of business acumen to operate a company at an above-average profitability level. It’s a strong indicator of high-quality management. Measuring a company’s profitability is easy. We can look at their profitability ratios and decide.
But more important here is to know if the company is operating at the above-average profitability levels. How to know it? By comparing the company’s ratios with that of its industry averages.
A company that displays numbers higher than its industry’s average can be called as profitable. To mark the most profitable share of an industry, we’ll look deeper. How? By analyzing their degree of profitability.
How do we identify the most profitable share?
Allow me to give you a brief into the algorithm of the pre-built screener of the Stock’s Engine.
#1. The Ratios
The algorithm makes use of four profitability ratios to do the analysis. Why only four? Because I think these four ratios cover almost all aspects of the profitability of a business.
- ROE: This ratio inspects the profitability of a company from the shareholder’s perspective. It is the ratio between the company’s net profit and shareholder’s capital. It highlights the efficiency with which the company is using the shareholder’s funds to generate profits. Read more about ROE.
- ROCE: It analyzes profitability from the perspective of the effective use of capital. It is the ratio between the company’s EBIT and all capital employed by the company to yield profits. In ROE, only shareholder funds are used for analysis. But in the actual world, companies also use debt. Employed capital considers both sources of capital to analyze the company’s profitability. Read more about ROCE.
- Operating Margin: It checks if the company’s operations are profitable enough or not. It is a true indicator of an inherently profitable business. The company’s top managers may not look at ROE and ROCE numbers, but the operating margin is critical for them. Read more about operating margin.
- PAT Margin: It analyzes the profitability of a company from the stock market’s perspective. For the stock market, more important is the net profit (PAT). Why? Because generally dividend payouts are based on PAT. Even the price valuation of the company’s stocks is evaluated with respect to the net profit (EPS). Read more about net profit margin here.
These four ratios in combination can do near complete profitability scrutiny of any company. A company that scores high on all these numbers will get a high score.
#2. Calculation of The Industry Averages
This part was more challenging for the algorithm. There were two issues to deal with:
- Market Share of Each Company: The computation of the industry’s average numbers is not as simple as finding a mathematical mean of a few numbers. Why? Because it is also essential to consider the size of individual companies. The company must get its due weightage corresponding to the size it occupies in its own industry.
- Basis To Judge The Size of the Industry: To do this, we can use multiple metrics. The most logical ones are revenue and net profit. If we also want to consider the market’s estimate of the size of a company, we can also include market capitalization.
What we are trying to do? To calculate the industry average, we are calculating the weighted average of profitability. Suppose there are only two companies in an industry. Company A’s market share is 65%, and it operates at a 12% margin. Company B’s market share is 35% and it operates at a 15% margin. In this case, the overall profitability of the industry will be 65% of 12% + 35% of 15%.
Though the maths look simple, when there are over 150+ industries and about 4,000 number stocks to deal with, it gets tricky. Add to it another layer of sizing each industry based on multiple metrics like revenue, net profit, market capitalization, etc.
But to get a near-accurate industry average number, this kind of computation is necessary. I’m sure a manual calculation of this nature will not be easy. Hence, to save time, my Stock’s Engine algorithm does these calculations. The algorithm is coded to estimate the weighted average profitability of an industry.
I would also like to highlight that, companies operating in an inherently profitable industry automatically get an extra advantage. The algorithm favours these companies. But it does not ignore the degree of profitability of companies operating in low-margin industries.
#2. Comparison Between The Company & Its Industry
There are two layers of comparison done by the algorithm of The Stock’s Engine to screen profitable stocks. It first compares the profitability number of the industry with their respective stocks. The second layer calculates the degree of overperformance by a company compared to its industry’s average figures.
The result is that it filters and scores those companies whose profitability numbers are better than the industry averages. Moreover, it also scores companies based on their degree of profitability. Please note that both these analysis is done based on the four ratios as explained above (ROE, ROCE, Operating Margin, and Net Margin).
These two layers of scoring generate a GMR Score for each stock. The stock with the highest GMR Score (usually 100) can be tagged as the most profitable share of the Indian stock market.
This is an approach that I personally use to identify the most profitable shares for myself. What is the proof that these are good stocks and will perform well in the future? Generally, such stocks outperform the market in total-return terms. In some cases, such stocks may not display immediate price movement, it will eventually come.
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