• MARCH 13, 2013

The brand-new tool for finding quality stocks

What comes to your mind when one says - 'this is a high quality company'. Strong return ratios; economic value addition; free cash flow generation; surplus cash balance; strong brands; high dividend payout. All these - attributes of companies of superior quality - would come to mind.

A relatively unknown financial measure that is 'gaining popularity' is termed as 'gross profitability'. And as per a leading business daily, this measure can be added to the above-mentioned list of quality parameters.

Gross profitability is calculated as follows:

Gross profitability = Gross profit / Total assets

Gross profits would only include only the cost of goods sold; i.e. the costs to manufacture the goods. As such it mainly takes into consideration raw material costs and changes in inventory. Hence, would largely be applicable to manufacturing firms.

As most other ratios, the higher the figure the better it is.

Essentially, what the ratio indicates is the value-add a company does on the raw material it procures. In addition, it gives an indication of a company's pricing power and how efficiently it makes uses of its resources. The latter being a measure of quality.

However, if you think about it, the gross profit margin is also a measure that pretty much indicates the same thing. But, looking at gross profit margin in isolation would not be right. For it is also important to take into account the total capital that has been used for arriving at gross profits.

Thus, this ratio can be considered similar to other popular return ratios like return on assets and return on capital. But where this differs is it aims to overlook the effect of high one-time costs that could have been made to propel growth in the future. It only takes into account how adept a company is in demanding a premium for the value add it has done to its raw materials. And if it scores consistently high marks here, other business problems are not that hard to get rid of.

We ran a query on companies forming part of the BSE-500 index to check out the results. We took the average gross profitability of the last five years and sorted them in descending order on the average figure. The following are the results of the same.

CompanyGross Profitabliity (5-yr avg.)
Nestle India Ltd.461%
Colgate-Palmolive (India) Ltd.426%
Hindustan Unilever Ltd.425%
VST Industries Ltd.367%
Castrol India Ltd.323%
Alstom India Ltd.303%
Balmer Lawrie & Company Ltd.292%
Whirlpool Of India Ltd.288%
Jubilant FoodWorks Ltd.258%
Godfrey Phillips India Ltd.247%
Data Source: ACE Equity

As you can see, the list does throw up a list of strong companies. Thus, it can be a good starting point for someone who wants to invest in quality stocks which are currently plagued by other business problems. If an investor can get a fair idea of whether other business issues have a good chance of sorting themselves out, then investments in these stocks can certainly be contemplated we believe.

If bought at reasonable enough valuations, these businesses have a better chance of outperforming the ones that have poor gross profitability which in turn end up being more value traps than really good value stocks.

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