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  • Rohit Musale, CFA

How to Spot a Good Business

In this post, I want to talk about a couple of ratios that I look at, when I am trying to find a good business.


But before I talk about those two ratios, I want to talk about something called as pretax operating earnings.


I want to explain this concept so that it will be easier for me to explain the two ratios.


So how do I calculate the pretax operating earnings of a company?


First, I take the revenue, which is 'revenue from operations'.


In this, I do not include 'other income'.


From the revenue, I remove the cost of goods sold, or cost of generating the revenue.


What is leftover, is called as the gross profit of the company.


From the gross profit of the company, I deduct two more expenses.


One is depreciation on fixed assets.


And second is, a bucket where I put all of these expenses:


Selling, General & Administrative, R&D.


I place them in one bucket.


And I deduct them from the gross profit.


So, gross profit minus depreciation, minus selling, general, administrative, research and development cost, which is a cost that every business, in general, has to incur.


When you remove those two expense items, what you are left over with, is the operating profit.


Out of the operating profit, I deduct the interest expense.


So, if the company has taken on some debt, I remove the interest expense from the operating profit.


What is left over, is the pretax operating earnings of the company.


This does not include other income.


I look at pretax operating earnings because, I want to compare the market value of the company with the pretax operating earnings, because this is the earning power of the company.


This tells me how much yield I am getting, pretax.


So, when I go to a bank to make an FD, they give me a rate which is a pretax rate.


That is why I am looking at pretax operating earnings of the company.


Let's come to the two ratios.


The first ratio is pretax return on equity.


Of course, the numerator is pretax operating earnings.


The denominator here, is the equity capital plus the retained earnings of the company.


This ratio tells me, on my equity invested in the company, how much am I earning pretax, at the operating level.


That is the first ratio.


The higher the ratio, the better.


The second ratio is pretax return on invested capital.


So in this case, the denominator is the invested capital.


Now, what do I mean by invested capital.


Invested capital means the amount of capital that is stuck in the business.


In invested capital, I include all of the assets of the company minus certain items, where money is not stuck. Example: Cash, Investments & Intangibles.


If you look at these two ratios, the higher the better.


But on a standalone basis, these ratios don't mean anything.


If you look at these ratios over a 10 year period, for one company, that gives you a very good picture of what is going on in the company.


So, for example, you might notice that, companies which do not have a lot of debt, are making a lot of money per dollar invested.


You will see that, the pretax return on invested capital keeps on increasing, because without investing much money, companies are able to generate a return.


But, for the same company you will find that, the return on equity is reducing.


Why does this happen?


This happens because, as the company makes money, cash starts to pile up.


And as cash starts to pile up in the company, the equity of the company expands, which is why, the return on equity over a period of time, goes down.


If you look at companies like Colgate, Castrol, VST Industries, they are making a lot of cash, they generate a lot of free cash flow.


So, the return on equity keeps going down, over a period of time, because the cash pile increases.


But, if you look at the return on invested capital, where I am removing the effect of cash, and investments and intangibles, you will see that, the return on invested capital is increasing over a period of time.


That is how I try to spot a good business.


So, these two ratios, I look at, for a company over a 10 year period.


The higher the two ratios, the better.


And if a company is showing, increasing return on invested capital, but decreasing return on equity, it doesn't mean that, it's a bad company.


It simply means that, cash is piling up, and the company doesn't know what to do with the cash.


So, this is one way of comparing the two ratios over a 10 year period.


Another way is, looking at different companies in the same sector and then looking at these two ratios.


That will tell you, who is the best guy in town.


So, have a look at these two ratios.


First, learn how to calculate pretax operating earnings.


That becomes the numerator for these two ratios.


Denominator is a very simple thing.


Only thing is, you need to learn how to calculate the invested capital.


Regards,


Rohit Musale, CFA


9 January 2023

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