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Today I'll be sharing how you can use a handful of metrics to determine the profitability of the companies you own shares of.

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Now for today’s piece:

How To Judge a Company's Profitability

Highlights

Profitability

When I first started investing, I wouldn’t focus on profitability. If it looked like the company had a good enough business model to be profitable in the future, that was enough for me to buy shares.

I no longer operate this way.

I want to own businesses that are profitable, not the ones hemorrhaging money.

It seems so simple but when I started investing, it wasn’t.

When you’re buying shares, you’re not just buying an imaginary thing that represents numbers on a screen. You’re becoming the owner of a business, and it's easy to forget that in the wild world of investing.

When I thought about this, I asked myself, “Why would I ever want to own a business that isn’t making money?”

Since then, I’ve only bought profitable businesses, and today I’m going to share the metrics I use to do so.

Return On Invested Capital (ROIC)

ROIC measures the profitability and efficiency of a company's capital investments.

It is calculated by dividing the company's operating income by the invested capital. Invested capital includes both debt and equity.

ROIC shows how effectively a company utilizes its capital to generate profits. A higher ROIC indicates better capital allocation and operational efficiency.

Companies with high ROIC are often very strong investments. Take a look at the current top 5 large-cap companies as measured by ROIC:

The 5-year returns are as follows (dividends not included):

NVO – 233.84%

ASML – 269.70%

AAPL – 286.16%

MA – 96%

TXN – 58.87%

These 5 businesses have shown that they are adept at investing capital and they’re deploying it at high rates of return within the business.

Return On Assets (ROA)

Return On Assets measures the profitability of a firm in relation to its assets. It is calculated by dividing the company's net income by its average total assets.

ROA indicates how well a company generates profits from its assets. A higher ROA suggests efficient asset utilization and effective management of the company's resources.

Warren Buffett calls See’s Candies a “dream business” because of its ability to create increasing profits without having to invest big sums of money into new assets.

Early in 1972, Buffett bought See’s Candies for $25 million. At that time, See’s had about $8 million of net tangible assets and was earning $2 million in profit, a 25% ROA.

Fast forward to 2007 and See’s had earned $82 million profit on $40 million of net tangible assets.

A 195% ROA!

The idea of finding a business like See’s that can provide amazing returns on a small number of assets is an investor’s dream.

By requiring just a small amount of capital to be spent on assets, the business can send the rest of its capital back to shareholders by way of dividends and share buybacks.

Return On Equity (ROE)

ROE measures a company's profitability in relation to its shareholders' equity.

It is calculated by dividing the company's net income by its shareholders' equity.

ROE represents the return earned by shareholders on their investment. It is an important metric for investors to assess the profitability and effectiveness of a company's management.

A higher ROE indicates better profitability and value creation for shareholders.

Companies with high ROE tend to be really strong investments too:

The list looks very similar to the ROIC list.

ROE and ROIC often go hand in hand, and they define strong companies.

If you look back in time, you’ll find that most of the companies with strong ROE then are still strong companies today.

This list is from 1993 and on that list are many names I consider to still be quality investments today.

Profit Margin

Profit margin measures a company's profitability by evaluating its net income in relation to its revenue.

It is calculated by dividing net income by revenue and multiplying the result by 100 to get a percentage.

Profit margin reflects the percentage of revenue that is converted into profit.

A higher profit margin indicates better profitability and effective cost management.

Simply put, the higher the difference is between what it costs the business to produce a product and what it can sell it for, the better the profit margin is.

A company that I really like with huge profit margins is LVMH. They post 18% profit due to their ability to charge high prices for their luxury goods.

Final Thoughts

When I’m looking at the profitability of a company I’m interested in, I compare its profit metrics to those of its competitors.

I buy shares of companies with sustained periods of profitability because they have the ability to reward shareholders with dividends and share buybacks, and will likely increase in value over time.

Try these metrics out when you look for your next investment!

Until next time,

Dr. “Profit” Dividend

Links & Memes

Here are some of the best things I saw this week:

• The story of Paul Tudor Jones making one of the best trades of all time – $9 million on one trade?!

• How the Dutch East India Company became the largest company in all of human history – it would be worth $7.9 trillion today!

Here are some of my favorite memes from the week:

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