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Evaluating Stock Trading Profitability
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Investors often judge companies by looking at which ones have in­ creased profits the most and assuming the trend will persist in the future. But more often than not, the firms that look great in the rearview mirror wind up performing poorly in the future, simply because success attracts competition as surely as night follows day. And the bigger the profits, the stronger the competition. That's the basic nature of any (reasonably) free market—capital always seeks the areas of highest expected return. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.

You can see this every day in the headlines. Why do generic drug firms em­ploy armies of lawyers to look for patent loopholes? Because large pharmaceu­ tical firms such as Pfizer and Merck are immensely profitable, and even one successful patent challenge will pay off in spades. Why were venture capitalists throwing money at every start-up firm in the networking industry during the late 1990s? Because Cisco was growing at 40 percent per year with operating margins of 25 percent. If a firm is generating big profits, it will surely attract competition.

The concept of economic moats is crucial to the way Morningstar ana­ lyzes stocks because a moat is the characteristic that helps great-performing companies to stay that way.

We've learned much about the subject by studying investment great Warren Buffett and Harvard professor Michael Porter, who first set down many of the main principles for analyzing competitive strategy and eco­nomic moats.

To analyze a company's economic moat, follow these four steps:

•  Evaluate the firm's historical profitability. Has the firm been able to gener­
ate a solid return on its assets and on shareholders' equity? This is the true
lkmus test of "whether a firm has built an economic moat around itself.

•  If the firm has solid returns on capital and consistent profitability, assess
the sources of the firm's profits. Why is the company able to keep com­
petitors at bay? What keeps competitors from stealing its profits?

•  Estimate how long a firm will be able to hold off competitors, which is the
company's competitive advantage period. Some firms can fend off competi­
tors for just a few years, and some firms may be able to do it for decades.

4- Analyze the industry's competitive structure. How do firms in this indus­ try compete with one another? Is it an attractive industry with many profitable firms or a hypercompetitive one in which participants struggle j ust to stay afloat?

Analyzing economic moats is complicated because there are a nearly infi­ nite number of solutions to the problem of consistently making a buck when your competition "wants to take it away, but the process is interesting for pre­ cisely the same reason.

Evaluating Profitability

The first thing we need to do is look for hard evidence that a firm has an eco­ nomic moat by examining its financial results. (Figuring out "whether a com­pany might have a moat in the future is much tougher, but we'll give it a shot at the end of this chapter.)

What we're looking for are firms that can earn profits in excess of their cost of capital—companies that can generate substantial cash relative to the amount of investments they make. One easy way to do this is by using the

EVALUATING PROFITABILITY 23

metrics in the following questions. Although none of these measures are per­ fect by themselves—they're really a series of shortcuts—they generally do a good job of identifying which firms have economic moats and which ones don't when they're used together. If you're confused by the financial measures in this section, don't worry: I'll discuss them in detail in the next few chapters.

Does the Firm Generate Free Cash Flow? If So, How Much?

First, look at free cash flow—which is simply cash flow from operations minus capital expenditures. (We'll go over free cash flow more in Chapter 5. For now, just go to a firm's statement of cash flows, which you can find in its quarterly and annual financial filings, look for the line item labeled "cash flow from operations," and subtract the line labeled "capital expenditures.") Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

Next, divide free cash flow by sales (or revenues), which tells you what pro­ portion of each dollar in revenue the firm is able to convert into excess profits. If a firm's free cash flow as a percentage of sales is around 5 percent or better, you've found a cash machine—as of mid-2003, only one-half of the S&P 500 pass this test. Strong free cash flow is an excellent sign that a firm has an eco­ nomic moat.

What Are the Firm's Net Margins?

Just as free cash flow measures excess profitability from one perspective, net margins look at profitability from another angle. Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales. (You can find sales and net income on a firm's income statement, which should also be in each of its regular financial fil­ ings.) In general, firms that can post net margins above 15 percent are doing something right.

What Are Returns on Equity?

Return on equity (ROE) is net income as a percentage of shareholders' equity, and it measures profits per dollar of the capital shareholders have invested in a company. Although ROE does have some flaws—"which we discuss in

24 ECONOMIC MOATS

Chapter 6 —it still works well as one tool for assessing overall profitability. As a rule of thumb, firms that are able to consistently post ROEs above iy per­ cent are generating solid returns on shareholders' money, which means they're likely to have economic moats. We'll go over ROE in more detail in Chapter 6.

What Are Returns on Assets?

Return on assets (ROA) is net income as a percentage of a firm's assets, and it measures how efficient a firm is at translating its assets into profits. Use 6 per­ cent to 7 percent as a rough benchmark—if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

When you're looking at all four of these metrics, look at more than just one year. A firm that has consistently cranked out solid ROEs, good free cash flow, and decent margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results. Consistency is impor­ tant when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time—not just for a year or two—that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and I'd strongly encourage you to go back IO years if you can.

In addition, these benchmarks are rules of thumb, not hard-and-fast cut­ offs. Comparing firms with industry averages is always a good idea, as is ex­ amining the trend in profitability metrics—are they getting higher or lower?

There's also a more sophisticated way of measuring a firm's profitability that Involves calculating return on Invested capital (ROIC), estimating a weighted average cost of capital (WACC), and then looking at the difference between the two. We'll talk more in Chapter 6, but don't worry if it seems too complicated for you. Using a combination of free cash flow, ROE, ROA, and net margins "will steer you in the right direction.

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