When we search for high-profit shares, we are searching for stocks with the most profitable underlying business. Stocks of extremely profitable businesses bought at a fair price can yield substantial returns over the long term. Check our list of profitable businesses

Our search for high-profit shares can be based on the following two approaches:

• 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.
• Business’s Profitability: This article will focus on identifying the most profitable shares based on this approach. For us, high-profit shares will be the ones representing such profitable business.

In this article, we will cover many aspects of the profitability analysis of companies. So keep reading and I’m sure you will pick something new from here.

List of High-Profit Shares

• Point#1: Point #1: Profitable Business – The Concept

• Point #2: Parameters Used To Identify Most Profitable Stocks

• – Four Profitability Parameters

• – Weightage Given To Each Parameter

• Point #3: How To Rate Stocks For Profitability – Steps

• Point #4: Use At least 5-Year Financial Data

• Point #5: Comparison Between WACC and ROCE To Establish Profitability

• Point #6: Profitability Analysis of Service-Based Companies Using Gross Margin

• Conclusion

Point #1: Profitable Business – The Concept

What is a profitable business? The answer must be simple, right? High-profit margin companies must be the choice. However, this simplistic definition of profitability may not be accurate. In our search, we must also focus on the following:

• Industry Focus: If we 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 sometimes 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 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.

Point #2: Parameters Used To Identify Most Profitable Stocks

Suppose we are given the task of Rating Companies on a scale of 1 to 100 for its profitability. What five most important parameters we will use to do the profitability analysis?

We would use parameters that cannot be easily manipulated by companies to show themselves artificially profitable. But we will also ensure that we are using only quantitative metrics that can be calculated using data from the company’s financial reports.

We will also ensure that we use such metrics that should work for all types of companies, like capital-intensive and non-capital-intensive companies.

Four Profitability Parameters

It’s essential to use quantitative metrics. It will help us to filter stocks using those numbers. It is also critical to rely on numbers that cannot be easily manipulated and that are applicable to various types of companies.

1. Operating Margin (OPM): Operating margin measures a company’s profitability from its core operations, excluding interest and taxes. It is calculated as (Operating profit / Revenue) * 100. Operating margin is less susceptible to manipulation because it focuses solely on operational efficiency. Read: Understand operating profit.
2. EBIT Margin: EBIT margin represents a company’s profitability before interest and taxes. It is calculated as (EBIT / Revenue) * 100. EBIT margin is less susceptible to manipulation because it excludes interest and tax considerations.
3. Return on Assets (ROA): ROA measures a company’s ability to generate profit from its assets. It is calculated as (Net Income / Total Assets) * 100. ROA takes into account the efficient use of assets, which is critical for both capital-intensive and non-capital-intensive companies.
4. Return on Capital Employed (ROCE): ROCE is a measure of how much profit the company is making from its employed capital. It can be calculated from this formula as (EBIT / Employed Capital) * 100. Employed capital represents the total assets of the company minus its current liabilities. Know more about ROCE calculation.

These listed parameters provide a universal measure of profitability that can be applied consistently across different industries and business models. making them suitable for a broader range of companies.

Weightage Given To Each Parameter

What individual weightage (importance) we must give to these five parameters while analyzing the profitability of a company?

Please remember that our focus is on long-term investors. Yes, the weightage will change if we change our viewing lens. For example, for a trader, looking only at the net margin is enough (100% weightage).

But a person who buys stocks to hold them for periods like five to ten years will need more than one parameter. Why? Because such an investor would like to evaluate profitability from all angles.

It is also true that not all parameters are equally important, hence we must allot a weightage to them to arrive at a certain conclusion.

1. OPM (35%): It reflects the company’s operational efficiency and profitability from its core business activities. For me, it is the most crucial indicator of sustainable profitability.
2. EBIT Margin (15%): It represents profitability before interest and taxes, which provides insights into the core operational profitability of the business. It complements the other metrics.
3. ROA (25%): It evaluates the company’s efficiency in utilizing its total assets to generate profit. For long-term investors, efficient asset utilization is critical for sustained growth.
4. ROCE (25%): It evaluates the company’s efficiency in utilizing its employed capital to generate profit. A company can have a large asset base, but if employs only a part of it in business, ROCE will differ from the ROA. For long-term investors, a high return on employed capital is a critical parameter.

These weightings are just a starting point and can be adjusted based on the investor’s preference.

Additionally, it’s crucial for long-term investors to consider other qualitative factors such as competitive advantage, management quality, and the company’s growth prospects. This is the reason why our Stock Engine uses a concept called the Overall Score. It is used to rate a stock based on six parameters including the profitability of its underlying business.

By assigning these weightings, we create a balanced framework for evaluating a company’s profitability. The weights give appropriate consideration to the company’s operational efficiency and asset utilization.

Point #3: How To Rate Stocks For Profitability – Steps

Suppose we want to rate stocks on a scale of 1 to 100 for profitability. We’ll follow a systematic process using the four parameters we discussed earlier. Let’s use a hypothetical example of a company, “ABC Corp,” to illustrate the steps:

Step 1: Gather Financial Data

Obtain the necessary financial data from ABC Corp’s annual reports or financial statements. We’ll need the company balance sheet, profit and loss accounts, and the cash flow report. Read point #4 as well.

It is also necessary for the analyst to know how to read these financial reports. In case one does not know how to read, simply picking specific parameters from the report will work. In case you want to learn more about reading and interpreting financial reports, check this article.

Step 2: Calculate Each Profitability Metric

Calculate the values for each of the five profitability metrics:

• (a.) Operating Margin = (Total Income – Other Income – Operating Expenses) / Total Income) * 100
• (b.) EBIT Margin = (Net Profit + Interest + Tax / Total Income) * 100
• (c.) ROA = (Net Profit / Total Assets) * 100
• (d.) ROCE = [EBIT / (Total Asset – Current Liabilities)] * 100

Step 3: Normalize the Metrics

To make the metrics comparable and suitable for rating, it’s essential to normalize them to a scale of 1 to 100. This normalization is done by scaling the actual values based on their relative performance compared to their industry average.

For instance, if ABC Corp’s Operating Margin is 12% and its industry average is 10%. We can use this formula to calculate its normalized value:

Normalized Value = (Company OPM / Industry's OPM) * 100

In our example of the company’s ABC Corp, the normalized OPM will be 120 (= 12 / 10 * 100)

Step 4: Assign Scores Normalized Weighted Values

Now, apply the weightage we previously determined to each normalized metric:

• OPM (35% weight) * Normalized OPM value
• EBIT Margin (15% weight) * Normalized EBIT Margin value
• ROA (25% weight) * Normalized ROA value
• ROCE (25% weight) * Normalized ROA value

Step 5: Overall Profitability Scoring

In this step, our example company ABC Corp will get an overall profitability score. It is done by summing up the normalized weighted scores for each four parameters.

Overall Profitability Score = Weighted Value (OPM + EBIT Margin + ROA + ROCE)

Step 6: Assign a Rating

With the overall profitability score calculated, we are now ready to assign a rating on a scale of 0 to 100.

Why do we need scoring? Because in our stock market, there are about 5000 number stocks. If we calculate their overall profitability score, some will get a score of say 70, some with get 800, and others will get different scores.

The higher the overall number the better. But to make the score more understandable for useful for the users, we must scale them between a range of 0 to 100.

To that, we use this formula:

Scale (0 to 100) = (Stock’s Score – Minimum Normalized Score) / (Maximum Normalized Score – Minimum Normalized Score)) * 100

• Stock’s Score = Overall Profitability Score of say the ABC Corp.
• Minimum Normalized Score = Out of all stocks under analysis (say S&P BSE500 stocks), pick the minimum score.
• Maximum Normalized Score = Out of all stocks under analysis (say S&P BSE500 stocks), pick the minimum score.

This method will convert the profitability scores of all stocks within the range of 0 to 100.

Step 7: Interpret the Rating

• A score near 100 indicates very strong profitability.
• A score in the 80s suggests above-average profitability.
• A score in the 60s or 70s might indicate average profitability.
• A score below 50 could indicate below-average profitability.

Point #4: Use At least 5-Year Financial Data

To get a more reliable conclusion about the company’s fundamentals, single-year data is not enough. So, let’s assume that you have the last five years data related to the operating margin of companies. How to use this data set?

Convert the last five-year data into a single number using the weighted average value concept.

When calculating a weighted average of the last five years’ operating margin you can assign weights to each year. This will create a balanced and meaningful representation of the company’s profitability history.

The choice of weights can depend on the specific context and our preferences. Here is an example of an approach that I’ve used in my Stock Engine’s algorithm in the past.

1. TTM – Trailing Twelve Months (30%): TTM data is the most recent and reflects the company’s current performance. Assigning a weight of 30% to TTM gives significant importance to the latest trends and conditions.
2. Year 1 – Last Year(20%): The data from the most recent fiscal year (Year 1) is still relatively current. Assigning a weight of 20% acknowledges the importance of the immediate past.
3. Year 2 (15%): The data from Year 2 is considered relevant, but it has less weight compared to more recent data to account for any changes or trends that may have occurred since then.
4. Year 3 (15%): Similar to Year 2, Year 3’s data is given a 15% weight to provide a balanced historical perspective.
5. Year 4 & Year 5 (10% each): The data from Years 4 & 5 receives a lower weight to reflect its diminishing importance as it moves further into the past.

This weighting scheme places more emphasis on the most recent data (TTM and Year 1) while gradually reducing the influence of older data points.

Point #5: Comparison Between WACC and ROCE To Establish Profitability

Comparing a company’s Weighted Average Cost of Capital (WACC) with its Return on Capital Employed (ROCE) is an effective method for profitability analysis.

The parameters like operating margin, gross margin, ROA, and EBIT Margin are focused on measuring profitability directly from the company’s income statement and cash flow statement. These metrics provide insights into different aspects of profitability:

On the other hand, comparing WACC with ROCE is a broader approach that considers both profitability and the cost of capital. This approach evaluates whether the company is generating returns that exceed the cost of the capital it employs. It is a crucial factor for companies to ensure shareholder value creation.

The WACC vs. ROCE/ROIC method provides a high-level assessment of whether a company is generating returns that exceed its cost of capital.

Point #6: Profitability Analysis of Service-Based Companies Using Gross Margin

You might have noted that I’ve not used Gross Margin as a parameter to do the profitability analysis.

Gross margin represents the profitability of a company’s core product or service, excluding operating expenses. It is calculated using this formula:

Gross Margin = ((Revenue – Cost of Goods Sold) / Revenue) * 100.

Gross margin is also difficult for companies to manipulate because it focuses on the cost of producing goods.

Analyzing service-based companies based on Gross Margins can be less informative compared to analyzing manufacturing or product-based companies. Gross Margin is typically more relevant for companies that have significant costs associated with the production or procurement of physical goods.

For service-based companies, the primary driver of profitability is often the efficiency of their operations, utilization of human resources, and pricing strategies. They do not have a product as such to sell. Therefore, while Gross Margin can still be calculated for service companies, it may not provide meaningful insights into their profitability or operational efficiency.

Conclusion

We have delved into the essential aspects of analyzing a company’s profitability.

Earlier emphasis was on the importance of selecting the right metrics and benchmarks for a comprehensive assessment. We’ve explored various profitability parameters, including Operating Margin, Gross Margin, EBIT Margin, ROA, and ROCE. Each of these metrics offers distinct insights into a company’s financial health.

It is also important to remember that we cannot RIL with TCS and arrive at a conclusion. The selected profitability ratios of a company must be compared with its industry average numbers. There are some industries that are inherently less profitable. An investor’s goal is to identify high-profit shares within an industry.

Have happy investing

Suggested Reading:

• Historical returns given by top Indian stocks
• When to sell stocks at a loss?
• Blue chip stocks in India
• Most undervalued stocks
• High dividend-paying stocks in India