Finding Quality Companies With Gross Profitability Ratio
The Gross Profitability Ratio is a qualitative metric gaining respect in the value investing community. Studies have shown the this ratio is able to provide valuable insight into which companies are more likely to outperform their peers in the future.
A high Gross Profitability Ratio is evidence that a company has sustainable competitive advantages. Otherwise competition would enter their business and lower their profits. The fact they have above average profits means they are able to execute a superior or favorable position over their competitors.
Gross Profitability = Gross Profit / Total Assets
A detailed post is available on the Arbor Investment Planner website for those who want to learn more about this ratio:
Gross Profitability Ratio – Qualitative Analysis – AAAMP Value Blog
We are going to examine three approaches to using the Gross Profitability Ratio to find quality companies:
Compare a List of Bargain Stocks.
Compare Stocks in the Same Industry.
Compare Stocks From a Special List (i.e. Dividend Aristocrats)
Compare a List of Bargain Stocks
My belief is that the best approaches in research are as simple as possible. It’s hard enough work as it is. Your initial screens can do much of the heavy lifting for you.
First screen for valuation. In this exercise we’re going to use EV to EBITDA, a popular and effective screen for finding companies selling at a low stock price. Then we will sort for Gross Profitability Ratio to help find quality companies for potential investment.
Enterprise Value / EBITDA (screen for valuation)
Gross Profitability Ratio (screen for quality)
I have chosen dividend stocks from the Arbor Dividend Analyzer database with an EV to EBITDA ratio of less that 10. For this example we have a list of stocks with relatively low valuations.
Here is the list of 18 stocks with an EV to EBITDA below 10 sorted by their Gross Profitability Ratio (from best to worst).
Bargain Dividend Stocks Sorted by Gross Profitability Ratio
(updated March 2017)
Div. Yield EV/EBITDA GP Ratio
Whole Foods (WFM) 1.8% 6.6 85%
Williams-Sonoma (WSM) 3.1% 6.6 78%
Gap (GPS) 3.8% 5.4 74%
Kroger (KR) 1.6% 7.1 70%
Best Buy (BBY) 2.6% 4.4 64%
Bed Bath & Beyond (BBBY) 1.3% 4.7 63%
Wal-Mart (WMT) 2.9% 7.6 63%
Target (TGT) 4.2% 5.7 55%
Guess (GES) 7.2% 4.4 47%
Sanderson Farms (SAFM) 1.0% 4.7 33%
Intel (INTC) 2.9% 9.1 32%
Verizon (VZ) 4.6% 7.5 31%
CVS Health (CVS) 2.2% 8.8 31%
LyondellBasell Ind. (LYB) 3.6% 6.9 26%
Altria Group (MO) 6.8% 6.8 25%
Cisco Systems (CSCO) 3.0% 8.7 24%
AT&T (T) 4.6% 7.4 22%
Cardinal Health (CAH) 2.1% 9.7 19%
Corning (GLW) 2.0% 5.3 13%
AmerisourceBergen (ABC) 1.6% 8.7 13%
This post is more about understanding the process than the individual investments (although there is value there too). Screening bargain dividend stocks for quality with the Gross Profitability Ratio is an approach to get good initial results, yet keep it relatively simple.
Virtually all of these stocks are worthy of further research based on their valuation alone. By screening with the Gross Profitability Ratio you would now have a great place to continue your research: At the top of the list!
Think how much easier this would make your research with a large list of stocks!
Compare Companies in the Same Industry
When comparing companies in different industries you might need to make allowances when making comparisons. For instance a retailer might need fewer assets than a utility to produce the same amount of profits.
The “cleanest”or most accurate use of the Gross Profitability Ratio is to compare stocks that are similar; for example, companies in the same industry. The idea is that these companies might have similar needs for assets (the denominator in gross profitability ratio) and face similar conditions that affect their gross profits (the numerator).
Here are 20 Industrial Stocks from the Arbor Dividend Analyzer data base sorted by Gross Profitability Ratio.
Industrial Stocks Sorted by Gross Profitability Ratio
(updated March 2017)
Div. Yield EV to EBIT GP Ratio
3M (MMM) 2.4% 16.8 46%
Illinois Tool Works (ITW) 1.8% 16.5 38%
Emerson Electric (EMR) 3.2% 15.5 33%
Cummins (CMI) 2.7% 13.1 30%
Stanley Black & Deck.(SWK) 1.8% 15.7 27%
Dover (DOV) 2.3% 18.5 24%
Parker-Hannifin (HP) 1.6% 16.3 22%
CSX (CSX) 1.5% 16.4 22%
United Technologies (UTX) 2.4% 13.1 18%
Boeing 2.6% 18.9 15%
Caterpillar (CAT) 3.3% 68.0 14%
Auto. Data Processing (ADP) 2.1% 17.6 13%
Lockheed Martin (LMT) 2.6% 15.4 11%
General Electric (GE) 3.2% 23.5 12%
L-3 Communications (LLL) 1.7% 15.8 8%
Waste Management (WM) 2.3% 17.9 8%
If you find stocks with a high Gross Profitability Ratio and a low Enterprise Value Ratio , you have a great candidate for further research. In the above list, Emerson Electric (EMR) and Cummins (CMI) stand out because they are near the top of the list, have above average dividend yields, and below average EV to EBIT ratios.
The goal of our dividend growth research is to find quality stocks at prices that offer a margin of safety . We want to buy at prices that offer a high probability of an above average return. That usually requires buying at a low price. If you pay a low price, and buy quality at the same time, your probability of success increases exponentially.
Compare Stocks From a Special List
Let’s use the Dividend Aristocrats for the exercise:
LIST OF 2017 DIVIDEND ARISTOCRATS
Dividend Aristocrats are S&P 500 companies which have increased their dividend for 25+ consecutive years. Therefore we know these stocks are already special. Sorting the Dividend Aristocrats by the Gross Profitability Ratio will give us some of the best of the best companies:
10 Dividend Aristocrats with Gross Profitability Over 50%:
(updated March 2017)
Div. Yield EV to EBIT GP Ratio
Target (TGT) 4.3% 8.2 55%
Wal-Mart (WMT) 2.9% 10.9 63%
Genuine Parts (GPC) 2.8% 13.2 52%
Lowe’s Companies (LOW) 1.6% 14.6 61%
VF (VFC) 2.9% 15.2 58%
W.W. Grainger (GWW) 2.0% 15.5 72%
Sherwin-Williams (SHW) 1.1% 17.2 88%
Colgate-Palmolive (CL) 2.1% 18.0 75%
Clorox (CLX) 2.3% 18.4 58%
Sysco (SYY) 2.4% 19.3 56%
By using a list such as the Dividend Aristocrats we start off with all quality companies. These 10 have a Gross Profitability Ratio in excess of 50% and have been sorted by valuation. You could begin your research at the top of the list because these are the stocks with the most attractive valuations.
The Gross Profitability Ratio is gaining credibility in value investing circles because it provides valuable and predictive qualitative analysis when combined with valuation metrics. Some analysts argue it is the single best qualitative metric with which to compare multiple stocks (particularly within the same industry) that have already been determined to be bargains.
You can use the Gross Profitability Ratio with other valuable ratios to find the best companies with reasonable valuations in which to invest your money wisely.
Related Reading: Gross Profitability Ratio – Qualitative Analysis – AAAMP Value Blog
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