New figures show that the profitability of UK quoted companies is hitting new highs. While concerns rage about the longer-term impact of Brexit in some parts, it seems that our largest stocks are riding a wave of global growth.
Companies reporting their figures between January and March this year saw their collective pre-tax profits jump by 158% to £153.8bn. Seven out of 10 companies managed to grow their profits, while nine out of 10 firms saw a rise in sales. The collective revenue figure rose by 20.8% to 1.33 trillion, according to the research by The Share Centre.
For investors, profitability is synonymous with strategies that target higher quality, reliable, financially strong firms. Yet when it comes to finding profitable companies, it's worth remembering that headline figures can sometimes be misleading. Eye-catching profit numbers can mask all kinds of adjustments and financial smoke and mirrors by executives who want to present their results in the best light. So a checklist of profitability measures can be a useful way of getting to the facts.
A quality checklist
One of the most popular measures of profitability is to look at how much bang a company gets from the pounds it invests in itself. This is called return on capital employed - or ROCE. A high return on capital, particularly over a long period, can be a pointer to stocks with strong and defensible brands and franchises that can be rolled out very profitably.
A second signpost to strong profitability is the percentage that a company keeps from selling its products after all costs have been deducted, or operating margin. High margins are often a hallmark of companies that can command high prices from their customers and have strong competitive advantages.
Competitive advantage is also something that can be explored by looking at what's known as return on equity. This is the technical term for comparing a company's net income to all the cash that investors have put into into it. It's a popular way of comparing the profitability of companies in the same sector. ROE varies from industry-to-industry, but 15% is generally thought to be desirable.
A final check in the hunt for profitability is a ratio called free cash flow to sales. This useful comparison measures the proportion of sales revenues that actually turn into cash after everything else has been paid. Companies are sometimes criticised for producing impressive-looking accounts yet fail to generate hard cash. This cash flow ratio should help to spot them.
With these profitability measures in mind, this week's Stockopedia screen puts them to work to get an idea of which FTSE 350 stock are the most profitable. The results are sorted by ROCE because it's a useful initial starting point in the search for profitability and efficiency. The table also includes the forecast PE ratio of these stocks to give an idea of how much investors are having to pay for them.
|Name||Mkt Cap £m||Forecast P/E Ratio||FCF/ Sales %||ROCE %||ROE %||Op Mgn % 5y Avg|
|Jupiter Fund Management||2,162||13.7||41.2||29.7||24.8||39.2|
|Euromoney Institutional Investor||1,546||18.7||17.7||28.7||39.3||20.7|
Source: Stockopedia Past performance is not a guide to future performance
This kind of screening approach results in some of the market's highest quality businesses. Among them are property website Rightmove and comparison website Moneysupermarket.com Group. Businesses like these benefit from dominant market positions that allow them to achieve superior profitability. There's also an element of cyclicality in these results, with companies like the mining group Ferrexpo and the housebuilders Berkeley Group Holdings (The) and Persimmon achieving strong profitability as their respective markets enjoy strong trading.
Overall, good quality, profitable companies are some of the most popular investments in the stockmarket. In the investor toolkit there are various ways of measuring that profitability - and they can be used on any occasion to separate those firms that are flattering their figures from those that are genuinely profitable.
It's worth remembering that highly profitable stocks can end up with expensive valuations that put them out of reach of investors with an eye for value. So it could be worth watching for momentary dips in price. As Warren Buffett famously noted:
"Whether socks or stocks, I like buying quality merchandise when it is marked down."
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