How to pick stocks (Part 2) - The profitability of a business

In my previous blog post, we discussed on economic moats and why it is important for us to identify which industry the company belongs to. If you have not read that post, you can read it here: How to pick stocks (Part 1) – Economic Moats

To know if a company is doing well in that industry, we can look at various metrics and financial ratios to give us a clearer view. This will give us a confirmation that it has a strong economic moat.

How to know if a company is generating profits?

Financial statements are important in our analysis of a company. It reports on the current health of the company such as how much revenue it is generating, how much money it is spending, how much debt it has, how much cash it has etc.

There are basically 3 types of financial statements we see in a company’s financial report namely:
1) The income statement
2) The Balance Sheet
3) The Cash flow Statement

We’ll discuss in depth the above 3 statements in a separate blog post. For now, we’ll just touch on a few simple financial terms to start with.


Free Cash Flow
To evaluate a company’s profitability, first we look at free cash flow. This is calculated by using cash flow from operations minus capital expenditures.

Free Cash Flow (FCF) = CF from operations – Capital expenditure (Capex)

The amount of cash flow from operations and capital expenditure can be found in the cash flow statement in a company’s financial report. Firms that are able to generate free cash flow essentially have money left over after reinvesting whatever they need to keep the business running. This includes spending on upgrading factories, building up properties, buying or replacing worn out equipments. Thus, free cash flow is whatever extra cash that the company can generate without damaging the core business.

Net Margins
Net margins is simply net income as a percentage of sales (revenue).

Net Margins=[(Net Income)/Revenue] x 100%

This shows us how much profit the firm can keep after deducting all the necessary expenditures. The net income and sales figures can be found in a company’s income statement. For example, if a firm has $50k in sales or revenue and net profit of $10k, we can say that this firm has a net margin of 20%. Firms that can generate more than 15% net margins are generally alright.

Return on Equity
Return on Equity (ROE) is net income as a percentage of shareholder’s equity. It measures how much profit per dollar the company is generating from the capital that shareholder’s have invested in. Firms that post a ROE of above 15% consistently are generating returns on shareholder’s money which means they are likely to have an economic moat.

Return on Assets
Return on Assets (ROA) is net income as a percentage of a firm’s assets. It measures how efficient the firm is in generating profits from its assets. If a firm can generate a ROA of 6-7% consistently, it may have some competitive advantage over its peers. ROE and ROA have already been calculated in percentages on most financial websites such as Bloomberg. You can use this website to view financial statements of companies and also the various financial ratios like ROE and ROA: http://investing.businessweek.com/research/company/overview/overview.asp

Conclusion 
What we've just discussed are just some simple ways we can evaluate a company’s profitability. It is important to look at the metrics comparing for a few years. If a company can consistently have good FCF, decent net margins, high ROE and ROA, then it has a stronger economic moat and can keep competitors away for an extended period of time. These are only just a guide for us when picking stocks.

There are many other ways to analyse a company and I will discuss it in subsequent blog posts. It is also important to compare companies against other companies in the same industry to see if it is truly ahead of competition.

In the next series, I will write on how to interpret the various financial statements. We'll also look at how to know if a company is worth buying at that current price by valuing the true value of the company against its stock price. Stay tune for more!

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Related Posts:
1. How to pick stocks (Part 1) - Economic Moats
2. Investing Basics - Low Cost Index Fund investing (Passive Investing)