HOW TO IDEN­TIFY A GOOD BUSI­NESS

Shares - - TALKING POINT -

How do we mea­sure whether a firm is good? Af­ter all, it’s hard to quan­tify the qual­ity of a firm’s prod­ucts, the value of its brands, the loy­alty of its cus­tomers or the skill of its man­age­ment in fi­nan­cial terms.

Rather than try to es­ti­mate a com­pany’s value, we should stick to what we know, start­ing with how much money it made last year and how much cap­i­tal it used in the process. In other words, what was its re­turn on cap­i­tal?

We’ve cov­ered re­turn on cap­i­tal as a mea­sure be­fore (see Shares, 30 Novem­ber 2017, How

ex­perts find the best com­pa­nies) but in a nut­shell the higher the re­turn, the bet­ter the busi­ness.

If in the nor­mal course of run­ning its busi­ness Firm A uses £1bn of cap­i­tal and gen­er­ates op­er­at­ing profit of £150m per year, its re­turn on cap­i­tal is 15%.

If Firm B also uses £1bn of cap­i­tal but only gen­er­ates £50m of op­er­at­ing profit per year its re­turn on cap­i­tal is just 5%.

That’s ob­vi­ously a bet­ter re­turn than the 1.5% yield on 10-year UK gov­ern­ment bonds (gilts), the risk-free al­ter­na­tive, but it’s not as good as Firm A.

It’s also only half the aver­age re­turn on cap­i­tal em­ployed for all the firms in the FTSE 100 (10.3%).

The rea­son that op­er­at­ing profit – also known as EBIT (earn­ings be­fore in­ter­est and tax) – is a bet­ter mea­sure than pre-tax profit is that com­pa­nies all have dif­fer­ent lev­els of debt and dif­fer­ent tax rates.

Com­pa­nies pub­lish their op­er­at­ing profit ev­ery quar­ter or ev­ery half year, mak­ing it easy to track, but they only tend to pub­lish cap­i­tal em­ployed in their au­dited full-year re­sults.

Help­fully on Shares’ web­site there is a record of both op­er­at­ing profit and cap­i­tal em­ployed so you just have to di­vide one by the other. Search for a spe­cific stock and then go the quote page. Click the ‘Fun­da­men­tals’ tab and you’ll find all the nec­es­sary data.

Re­turns on cap­i­tal tend to be higher for busi­nesses with few fixed as­sets and lit­tle work­ing cap­i­tal than for com­pa­nies with lots of fixed as­sets (like elec­tric util­i­ties) or those that need lots of cap­i­tal (like banks).

Us­ing re­turn on cap­i­tal as a mea­sure of how good each busi­ness is, we can now rank them from best to worst.

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