[Updated: 31-Jul-2021] When we inquire about the best profitable shares, what actually do we mean? We mean those shares which have proved most profitable for its investors. How to identify such shares? [Check the updated list here…]
There can be two types of approaches to answering this question. The first is based on historical ‘price appreciation, and the second is based on ‘profitability of the underlying business.
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In the ‘price appreciation approach’, one can check the past price growth rate, and accordingly decide if the stock has been profitable or not. Example: Market price growth of TCS in the last 5 years has been 14.5% per annum.
Judging the profitability of stocks based only on its price appreciation is like incomplete work. It is mandatory to also look into the profitability of the underlying company to take a more reliable decision.
In ‘profitability’ approach, one can check if the underlying company is inherently profitable. How to do it? Check the following:
- Profitable Sector: A company which is operating in a sector which itself is profitable, eventually makes the company also profitable. Which are these sectors? These are essentially those sectors where competition is less. Read more about economic moat.
- High Operating Profit Margin: A company whose ‘operation’ generates more profit per unit cost consumed can be called ‘inherently profitable’. Operating Profit Margin is a perfect financial metric which highlights such inherently profitable companies. Read more about profit margin analysis.
- High ROE: Operating profit sees ‘inherent profitability’ from operations point of view. ROE sees this from shareholder’s point of view. A company which is generating more profit for every dollar of shareholder’s money (Equity), can also be called as inherently profitable. ROE is a great metric to highlight such companies. Read more about how to calculate ROE.
The above three parameters will help us to identify potentially profitable shares which are being traded in Indian stock market. But there is a small problem. It is not easy to check profitability of a sector as a whole.
Go for a shortcut?
Why not straight away pick those stocks which has high operating profit and high ROE?
Sure this can be done. But adding one more layer of safety will only help us as an investor. How? Because there are less chances of companies making a loss which operates in such a sector.
Hence, no matter how difficult it is to judge profitability of a sector, we will try to estimate it anyways. Idea is to identify most profitable sectors of Indian stock market.
Once we have such a data, we will pick good stocks operating in these sectors. These stocks will be ‘inherently’ most profitable shares of Indian stock market.
So let’s start our analysis.
Screening Profitable Shares
To identify profitable shares, we will use the below steps:
- Profitability of Stock Market: In this step we will try to estimate the average profitability of the whole Indian stock market. How to do it? We’ll pick all stocks listed in S&P BSE-500 Index. Average ROE and Operating profit margin of all these stocks will give us an approximate idea of the profitability of Indian stock market. Read more about what is share market.
- Profitability of Sectors: In this step we will pick those sectors, whose average profitability is more than the average profitability of the total market. These will be our ‘most profitable sectors’. Know about stock’s having high weightage in Sensex Nifty.
- Profitable Shares: Among the profitable sectors, we will individually check all their stocks. The stocks which will display high operating profit margin, and high ROE will be those stocks which we will tag as ‘inherently profitable shares’. How to use RoCE and ROE to identify profitability.
- Price Growth: This is the final step. The list of stocks which we will tag as inherently profitable, on these stocks we will do one more check. We will check their past price growth rates. This will be done just to understand if the strong fundamentals of the company has actually translated into price appreciation or not. Read more about highest return stocks in last 10 years.
I’ve implemented the above 4 steps and identified few Indian stocks which looks inherently profitable. Let’s see how the same has been implemented.
Step #1: Profitability of Stock Market
Individual stocks of Nifty-500 index are representative of their sectors. Hence it is safe to assume that Nifty-500 index in totality is also a reliable representative of the whole Indian stock market.
So just to get a macro view of the Indian stock market, I will try to estimate the profitability of it. How to do it?
- Calculate profitability of individual stocks (500 nos).
- Calculate average of these 500 stocks.
What will be the measure of profitability of individual stocks? Operating Profit and ROE. So here is the first result: overall profitability of Indian stock market:
Overall profitability of “Indian stock market” is as below:
- Operating Margin: 22.92%
- ROE: 13.69%
Knowledge about these two values will give us a better visualisation of most profitable sectors. How? Sectors that has Operating margin and ROE above the market average, will be necessarily more profitable.
Step #2: Profitability of Sectors
All stocks listed in Indian stock market can be broadly classified into the above 15 sectors.
How to comprehend the above data? In two different ways:
- FIRST, compare profitability of the ‘overall stock market’ with each individual sector. This will give a nice visualisation that how profitable are the individual sectors compared to the average (overall market). Example: To understand how profitable is “Energy” sector, compare its percentile rank with that of the total market. Overall Market: 70.3%, Energy Sector: 92%. This comparison gives an idea that Energy sector is inherently more profitable than the average stock market.
- SECOND, compare profitability of one sector with another. This will again give a nice visualisation that how profitable are each sectors compared to each other. Example: Suppose you want to understand which sector is more profitable than Energy sector. From the above table you can see that only Auto sector’s percentile rank (100%) is above Energy sector.
The usage of percentile ranking has dual benefits. It not only highlights which sectors are more profitable, but it also highlights the degree of profitability of sectors with respect to each other.
Let’s consider a case of Financial sector (83%) and Technology sector (82%). Though Financial sectors rank is higher, but in terms of ‘degree of profitability’, there is hardly any difference between the two. Means, both are almost identical.
Similarly, compare FMCG (Rank 6th) & Chemical sector (Rank 7th). Though they are separated by only one rank, but in terms of Percentile Rank, their difference is close to 10%. Means, FMCG (80%) is much more profitable than Chemical sector (70.4%).
Step #3: Identify the most profitable shares operating in above sectors
In Step 2 we were able to identify 7 sectors whose profitability is higher than profitability of the average market.
Now our task is cut out to find profitable shares within these 7 sectors. How to find these shares? This will be done in two steps:
- Step A: First we will pick those stocks from these 7 sectors whose profitability is more than that of the stock market.
- Step B: Then we will rank these shortlisted stocks in order of their profitability. Idea is to prepare a short list of most profitable stocks in India.
Please check the bottom of the post for the list of stocks.
Step #4: Past Price Growth
This step is not essential, but I do it anyways for myself. Why I do it? Because it gives me a good feel about my shortlisted stocks. How?
What we have done in Step1 to Step3 is shortlisting stocks based on their business fundamentals.
In Step4 will will verify if the strong fundamentals of these stocks has actually translated into their long term price growth or now.
Please check the bottom of the post for the list of stocks with their past 10 year price growth rate.
This is an approach which I personally use to identify most profitable shares for myself. What is the proof that these are good stocks and will perform well in future? Frankly speaking there are no proof to confirm future performance. But I believe that this kind of profitability analysis can never let its analyst down.
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