HOW TO IDENTIFY A GOOD BUSINESS
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.