In the previous article, we discussed how to look for fast-growing companies just by looking at Profitability and Growth – the two elements that, if coupled with the profit margins, provide a glimpse of a company’s competitive strength, a.k.a Moat.
But here’s the catch.
As wonderful as these companies may seem at the first glance,
some of them are not exactly the most efficient, which, in the long run COULD affect you as a shareholder.
(although for the record, some of them ARE truly that wonderful)
Think of them as sports cars that can accelerate very fast; like, 10-mph-to-120mph-in-5-seconds kind of fast.
Exhilarating, yes, but they are not exactly fuel-efficient and would consume more petrol than your average sedan. Thus, wasting a lot of unnecessary resources.
Likewise, a fast-growing company may move at a brisk pace, but it may not be growing in the most efficient manner.
In this article, we will look at how to find the most efficient companies among the growth companies that we have narrowed down.
In other words, not just the fast cars, but the equally efficient ones.
How do we do that you ask?
Well… we look at the Return on Equities (ROE) and Gross Profitability Ratio.
1. Return of Equities (ROE)
By looking at ROE, we can understand how much net income a company can generate based on the shareholder’s equity.
It is also seen as one of the management assessment metrics, which determine how efficiently the management team can generate profit using shareholders’ fund.
For this instance, let’s look at two growth stock examples – Facebook and Snap Inc.
Looking solely at the 5-year Return on Equity, Facebook’s ROE has always been positive and in double-digits, which is very impressive.
However, for Snap Inc, whose ROE has been consistently negative, the management does not seem to be able to make the best out of the shareholders’ funds and generate any profit for them.
In other words, Snap Inc’s investors have been suffering losses and it doesn’t seem they are getting their money back anytime soon – whatever amount that was invested in the company have not turned a profit so far.
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The downside to calculating a company’s efficiency with ROE though, is that both companies would need to have positive net income and shareholder’s equity.
If one of them is not generating any profit, the ROE’s relevance may be rendered moot.
Fortunately, there are other ways around the process when that happens.
The Gross Profitability Ratio.
2. Gross Profitability Ratio
This ratio looks at the amount of gross profits generated for each dollar of assets in the company.
In this case, we use Gross Profits as it is often seen as a figure that is less likely to be manipulated. To calculate the Gross Profitability, we simply divide the Gross Profits by the company’s Total Assets.
Let’s look at Facebook and Snap again.
Here, we can observe that both Facebook and Snap’s Gross Profitability Ratio have actually been improving along the years.
However, as we can see, Facebook is still proven to be the far more superior among the two.
ROE and GPR can sometimes be difficult to detect in an average financial report, and even then, if you are analyzing more than one company, you’ll have to leave through at least 50 financial reports to get a definitive answer.
(Remember our article last week on why Warren Buffett made it point for an investable company to have at least 5 years’ worth of track record?)
That’s why WealthPark have also made it a point to make things Smarter, Faster and Easier for investors like you and me…
And summarized all of the above into a simple chart – The Star Chart, under Profitability.
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To summarize, apart from high growth rates and good profit margins, growth stocks will be considered far more superior if they also has high Return On Equity and high Gross Profitability Ratio.
If at this point, you’re asking “Is there anything else one should look out for in growth investing, apart from speed and efficiency?”
Why yes, there is.
Imagine this. A person may be able to run very fast, and very efficiently (make of that what you will), but underneath it all, he may not at the pink of health. Like physiological ailments, some growth stocks may have an underlying health problem that may not be visible to the naked eye at first.
So, in the next article, we will find out how to detect these “ailments” in a company; in other words, whether or not a company is healthy.
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author(s) involved in the writing of this piece do not have current vested interest of the company. Please consult a competent professional for expert financial, or other assistance or legal advice.