Pick Stock Profitability

Now we come to the second—and, in many ways, most crucial—part of the analysis process: How much profit is the company generating relative to the amount of money invested in the business? This is the real key to separating great companies from average ones, because the job of any company is to take money from outside investors and invest it to generate a return. The higher that return, the more attractive the business.

I've already briefly discussed profit margins and the importance of understanding whether cost cuts or price hikes are driving an increase in profit margins. Comparing cash flow from operations to reported earnings per share is another good way to get a rough idea of a firm's profitability because cash flow from operations represents real profits.

But neither net margin nor cash flow from operations accounts for the amount of capital that's tied up in the business, and that's something "we can't ignore. We need to know how much economic profit a firm is able to generate per dollar of capital employed because it will have more excess profits to reinvest, which will give it an advantage over less-efficient competitors.

Think about it this way—a company's management is similar to the manager of a mutual fund. A mutual fund manager takes investors' money and earns a return on it by investing in stocks and bonds. Wouldn't you rather put your money with an equity manager who has consistently generated returns of 12 percent per year than one who has returned an average of only 9 percent per year?

Companies aren't much different. They take shareholders' money and invest it in their own businesses to create wealth. By measuring the return that a company's management has achieved through this investment process, "we know how good they are at efficiently transforming capital into profits. Just like a mutual fund, a company whose management is investing well enough to generate returns on capital of 12 percent is usually a more attractive investment than a company that returns only 9 percent on its capital.

Our two tools for assessing corporate profitability are return on capital and free cash flow. I start with return on assets (ROA) and return on equity (ROE), which we first saw in Chapter 3 when we evaluated economic moats. Then I'll show you how to compare free cash flow to ROE and I'll finish up with a quick discussion of a sophisticated measure of profitability called return on invested capital (ROIC).

net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets.

Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits. We can see this easily when we compare a top-notch retailer such as Best Buy with a firm like Circuit City , which was struggling in the late 1990s and early 2000s. Since 1998, Circuit City 's returns on assets have been around 4 percent to ; percent, whereas Best Buy's improved from 5 percent to almost 10 percent (see Figures 6.3 and 6.4.)

Higher profit margins—almost 3 percent for Best Buy and below 2 percent for Circuit City —are part of the picture, but higher asset turnover is a bigger differentiator between the two. In 2OO2, for example, each dollar that Circuit City had invested in property and inventory (the two biggest assets for most retailers) generated about $2.50 in sales, while the same dollar invested by Best Buy generated S3.20 in sales. Clearly, Best Buy was running a more efficient shop than Circuit City and was much better at transforming its assets into profits.

1.9	1.4	2.0
3.2	3.0	2.5
6.1	4.2	5.0

Net margin (%) 1.4 1.6

Net margin (%)	1.1	2.2	2.8	2.6	2.9
Asset turnover (average)	4.4	4.4	4.5	3.9	3.2
Return on assets (%)	4.8	9.7	12.6	10.1	9.3

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly. Often, you'll see companies with lower profit margins, such as grocery stores and discount retailers, emphasize high asset turnover as a way to achieve solid ROAs. For any business that can't charge a big premium for its goods, tight inventory management is critical because it keeps down the amount of capital tied up in assets, which helps pump up return on assets. On the flip side, companies that can mark up their goods in a big way—a luxury retailer such as Tiffany, for example— can afford to have more capital tied up in their assets because they make up for low asset turnover with high profit margins.

Just using ROA would be fine if all companies were big piles of assets, but many firms are at least partially financed with debt, which gives their returns a leverage component that we need to take into account. Our next measure of returns on capital, return on equity, lets us do this.

Return on equity is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity—in other words, it measures how good the company is at earning a decent return on the shareholder's money. Think of it as measuring profits per dollar of shareholders' capital.

Because Return on assets = Net margin X Asset turnover, ROE in all its glory equals:

You'll notice that we've introduced a new metric—financial leverage, which Is essentially a measure of how much debt a company carries, relative to shareholders' equity. Unlike net margin and asset turnover—for "which higher ratios are almost unequivocally better—financial leverage is something you need to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster.

Look at the kind of business the firm is in. If It's fairly steady, a company can probably take on large amounts of debt "without too much risk because there's only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments. On the flip side, be very wary of a high financial leverage ratio if a company's business is cyclical or volatile. Because interest payments are fixed, the company has to pay them "whether business is good or bad.

Therefore, we have three levers that can boost ROE—net margins, asset turnover, and financial leverage. For example, a firm could have only so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g., a well-run discount retailer such as Wal-Mart). Companies with high asset turnover are extremely efficient at extracting more dollars of revenue for each dollar they have invested in hard assets. A firm could also excel at convincing customers to pay up for its products— asset turns might be just middling, and the firm might not have much leverage, but it would have great profit margins (e.g., a luxury goods company such as Coach). Finally, a firm can boost its ROE to respectable territory by taking on good-size amounts of leverage (e.g., mature firms such as utilities).

Although It's tough to generalize, let me offer some rough benchmarks for evaluating firms' ROEs. In general, any nonflnancial firm that can generate consistent ROEs above 10 percent without excessive leverage is at least worth investigating. As of mid-2003, only about one-tenth of the nonflnancial firms in Morningstar's database "were able to post an ROE above 10 percent for each of the past five years, so you can see how tough it is to post this kind of performance. And if you can find a company with the potential for consistent ROEs over 2O percent, there's a good chance you're really on to something.

Two caveats when you're using ROE to evaluate firms: First, banks always have enormous financial leverage ratios, so don't be scared off by a leverage ratio that looks high relative to a nonbank. (We go over how to evaluate banks' financial health in Chapter 17.) In addition, because banks' leverage is always so high, you want to raise the bar for financial firms—look for consistent ROEs above 12 percent or so.

The second caveat concerns firms "with ROEs that look too good to be true because they're usually just that. ROEs above 40 percent or so are often meaningless because they've probably been distorted by the firm's financial structure. Firms that have been recently spun off from parent firms, companies that have bought back many of their shares, and companies that have taken massive charges often have very skewed ROEs because their equity base is depressed. If you see an ROE over 40 percent, check to see if the company has any of these characteristics.

In the previous chapter, I introduced you to cash flow from operations (CFO), which measures how much cash a company generates. As useful as CFO is, it doesn't take into account the money that a firm has to spend on maintaining and expanding its business. To do this, we need to subtract capital expenditures, which is money used to buy fixed assets. The result is free cash flow:

Thinking back to our hot dog stand example, suppose Mike "was so successful that he decided to use the cash he'd generated to build a second hot dog stand. The cost of building that stand would be posted to "capital spending," and subtracted from free cash flow.

Why? We need to be able to separate out businesses that are net users of capital—ones that spend more than they take in—from businesses that are net producers of capital because it's only that excess cash that really belongs to us as shareholders. You may sometimes see free cash flow referred to as "owner earnings," because that's exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company's ongoing business.

A firm that generates a great deal of free cash flow can do all sorts of things with the money—save it for future investment opportunities, use it for acquisitions, buy back shares, and so forth. Free cash flow gives financial flexibility because the firm isn't relying on the capital markets to fund its expansion. Firms that have negative free cash flow have to take out loans or sell additional shares to keep things going, and that can become a risky proposition if the market becomes unsettled at a critical time for the company.

As with ROE, it's tough to generalize about how much free cash flow is enough. However, I think it's reasonable to say that any firm that's able to convert more than 5 percent of sales to free cash flow—just divide free cash flow by sales to get this percentage—is doing a solid job at generating excess cash.

One good way to think about the returns a company is generating is to use the profitability matrix, which looks at a company's ROE relative to the amount of free cash flow it's generating. Figure 6.5 shows free cash flow along one side and ROE on the other side, and this matrix can tell you a great deal about the kind of company you're analyzing.

Companies such as Microsoft, Pfizer, and First Data all have very high ROEs. People write books about how to manage a business as well as these companies do, and it's easy to see why—they're all money machines. Investors pour new money into them, and large amounts of extra money get spit out. Their managements are very, very good at earning a high return on shareholders' money.

If you follow any of these companies at all, you'll notice they have another thing in common besides high ROEs—their stocks all had valuations that were high during the bull market of the 1990s. Again, it's easy to see why: A company that can earn a high return on its shareholders' money is worth more to those same shareholders.

Looking at the other axis, we see that these companies are also very good at generating free cash flow. Pfizer, for example, generated more than $8 billion in free cash flow in 2OO2. That's $8 billion Pfizer made after spending whatever it needed to invest in its business. Pfizer could have chosen to pay

	Less Risky Companies
Qualcomm	Microsoft
Yahoo!	Pfizer
Novell us	Paychex
Electronic Arts	McGraw-Hill
MGM Mirage	First Data
Genentech	Home Depot
More Risky Companies
Jet Blue Airways	Lowe's
Ciena	Cheesecake Factory
Foot Locker	Southwest Airlines
Amazon.com	Walgreen
Nextel	Costco
	Comcast

that $$ billion—which worked out to about Si.31 per share—out to shareholders. In fact, that's exactly what older, more mature companies often do with their free cash flow. Their businesses aren't growing very fast, and they figure that shareholders can earn a better return on the free cash flow than they can. So, they return it to shareholders in the form of dividends. (This is "why slow-growth firms often have such high yields.)

Pfizer, on the other hand, thinks that it can figure out a way to invest that $8 billion more profitably than its shareholders. Because the company is in a relatively fast-growing area of the economy—health care—and has a solid track record of turning out profitable new drugs, it may very well be able to do so. However, if Pfizer started to pile up cash on its balance sheet the way Microsoft has over the past several years, we'd probably conclude that the company doesn't have many profitable avenues for reinvesting its excess profits. In this case, we'd want the firm to pay a dividend or buy back shares. Although Microsoft's dividend isn't very large at this writing, at least the company has one, which means that it has recognized that internal reinvestment opportunities are diminishing.

On the bottom half of the matrix, we have companies such as Amazon .com, JetBlue, Comcast, and Lowe's, which generate low or negative free cash flow. Companies like these aren't generating much free cash because they're using all the cash their businesses generate—and then some—to invest in expansion. They're investing heavily because they hope that those expansion efforts will pay off in the form of fat profits in the future. Amazon, for example, is spending heavily on building a brand and expanding its Web site, while JetBlue is spending heavily on new airplanes so that it can expand its service to new cities.

JetBlue and Amazon are like young entrepreneurs. They've taken out loans and maxed out their credit cards, and they're plowing every cent they have into building and expanding their businesses. Although they're not earning much in the way of profits right now, folks are investing in their businesses because they expect these companies to be very profitable sometime in the future, which is when investors will be rewarded. Pfizer, on the other hand, is more like a successful, middle-age businessman. He's already proven he can earn a good return on shareholders' money, so folks line up outside his door for the privilege of investing in his ventures.

You'd be taking a lot less risk investing with the older businessman than you "would with the young entrepreneur—though that entrepreneur might just pay you back many, many times over. Just remember that for every Jeff Bezos or Steve Jobs, there are literally hundreds of entrepreneurs who never paid their investors a dime.

There's nothing wrong with investing in the entrepreneurs of the world, as long as you know what you're getting into. A profitability matrix can help you separate your long shots from your core holdings.

Think of the profitability matrix like this: That upper right-hand corner, where Pfizer sits, is the sweet spot—excess cash and the ability to earn a high return on it. Companies in this square tend to be the cream of the crop and have a low level of business risk. (They might be very risky stocks, though, if they're trading at high valuations.)

Moving down to the bottom right, where Lowe's is, you see companies that are reinvesting all of their cash in expansion but are still able to generate a high return on shareholders' money. If these firms still have profitable reinvestment opportunities, they should be spending all the cash they generate on expansion. For example, Starbucks and Home Depot posted high ROEs and negative free cash flow all through the 1990s because they were plowing every cent they earned into building more stores.

In the bottom left are young companies growing like weeds, but which haven't yet proven that they can earn a decent ROE—they're spending tons of money, but they're not yet making it pay off very well. This is "where the most speculative companies hang out. These companies are generally long shots because it's still unclear whether all of that heavy investment "will ever generate an attractive return.

Return on invested capital is a sophisticated way of analyzing return on capital that adjusts for some peculiarities of ROA and ROE. Although you needn't worry about calculating it for yourself—it's pretty complicated—it's "worth knowing how to interpret it because it's overall a better measure of profitability than ROA and ROE. (If you are interested in how to calculate it, see the ROIC box.)

Essentially, ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing: It removes the debt-related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of profits than ROE and ROA, both of which use net income. ROIC uses operating profits after taxes, but before interest expenses. Again, the goal is to remove any effects caused by a company's financing decisions—does it use debt or equity?—so that we can focus as closely as possible on the profitability of the core business.

What does all this mean to you if you hear someone talking about ROIC? Simply that you should interpret ROIC just as you would ROA and ROE— a higher return on invested capital is preferable to a lower one. Warning: The material in this box drifts dangerously close to finance-geek territory. If hard-core finance puts you to sleep, ignore this box and don't worry about the inner workings of ROIC and WACC.

The true operating performance of a firm is best measured by return on invested capital (ROIC), which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple:

The numerator of this equation is easy: profits aftertaxes, but before interest costs. The denominator is a bit trickier, and although there are many different ways to calculate it, you'll do just fine if you use this version:

Let's run through an example: At the end of fiscal 2002, Wal-Mart's total assets were worth $94.7 billion. Subtract accounts payable, accrued liabilities, and accrued income taxes, and $67.7 billion remains, which is Wal-Mart's invested capital. Looking at the firm's income statement, we see that operating profit was $13.6 billion. If we m ultiply this by the firm's 36 percent tax rate, we get a rough idea of what taxes would have been without any interest income or interest expense (remember, interest is tax deductible for corporations), and we find that NOPAT equals $13.6 - ($13.6 x 0.36) = $8.7 billion.

Next, divide NOPAT by invested capital, or $8.7 billion by $67.7 billion, and ROIC is 12.9 percent — pretty respectable for a firm as large and mature as Wal-Mart.