Introduction
COMPANIES WITH A durable competitive advantage thrive because they can compete effectively and deal with market pressure. Accounting numbers can be used to see if the company is likely to have some form of competitive advantage. This chapter discusses key numbers to look at and how to interpret them.
Return on capital and equity employed
Recall from chapter 2 that return on capital employed (ROCE) measures the return generated by a company on the capital available (including long-term borrowing), while return on equity (ROE) measures the rate of profit earned by a company for its shareholders. Companies with a strong, durable competitive advantage can generate high ROCE and ROE compared with their peer group.
Morningstar provides a history of ROCE and ROE on the balance sheet or ratios page of the financial section.
For income and value companies, check whether the company’s five-year average ROCE and five-year average ROE are above 10%. For growth companies, an average ROCE and average ROE above 15% is acceptable, but above 20% is preferred. Avoid investing in companies with consistently low, single digit ROCE and ROE. Ideally, the trend in ROCE and ROE should be stable or on a gradually rising trend.
Example
Table 8.1 shows the historic returns achieved on capital and equity by XP Power. ROE is consistently above 20%, while ROCE has remained above 20% since 2010, which suggests the company has a competitive advantage. ROCE averaged 23.9% and ROE averaged 24.9% over the past five years.
Table 8.1 Return on capital and equity employed – XP Power
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
|
ROCE (%) |
17.2 |
14.6 |
31.1 |
33.7 |
22.9 |
26.4 |
26.0 |
22.8 |
21.4 |
23.0 |
ROE (%) |
30.1 |
25.3 |
43.8 |
41.3 |
26.6 |
27.9 |
26.0 |
23.4 |
21.9 |
25.5 |
Operating margin
Companies with a durable competitive advantage tend to have reliably higher profit margins, as they can consistently set a price above cost. Morningstar lists the operating margin history on the ratio page in the financial section.
Companies with a competitive advantage will normally have operating margins above 20%. Operating margins below 10% indicate that the company has no sustainable competitive advantage. Check that the current operating margin and the five-year average operating margin are above 10%. Ideally the trend in operating margin should be stable or gradually improving. Avoid companies with operating margins in low single digits.
Example
Table 8.2 shows the operating profit margins for XP Power. While margins have been above 20% since 2010, this dropped to just below 20% in 2017. However, the operating margin averaged 22.2% over the past five years, suggesting that XP Power has a competitive advantage.
Table 8.2 Profit margins – XP Power
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
|
Operating Margin (%) |
12.1 |
14.3 |
21.5 |
24.4 |
22.5 |
23.2 |
23.7 |
23.4 |
21.2 |
19.6 |
Consistency score
Companies with a durable competitive advantage will normally be profitable and have steadily growing sales, earnings and dividends. A consistency score measures how consistently the company has made a profit, paid a dividend and grown revenues, profits and dividends.
For a company with ten years of history the score lies between 0 and 50, with a high score indicating a more reliable company. Looking at the ten-year history for EPS, every positive year scores 1 point. Then, looking at the ten-year history of dividend per share (DPS), score 1 point for every year the company paid a dividend. Next, look at the ten-year histories for normalised EPS, revenue and DPS and score 1 point for every year a new high is reached in each of the series. (Note that the first observation is counted as a new high if it is positive.) Adding up the points gives the consistency score.
This score is usually converted into a percentage as not every company will have ten years of data readily available. When ten years of data is available the percentage consistency score is calculated by dividing the consistency score by 50. If there are fewer years, the denominator is the number of years available multiplied by five.
Consider eliminating companies that have a consistency score of 25 or less (or less than 50% if converted to a percentage). You should generally prefer companies with a consistency score of 40 or more (or more than 80% if converted to a percentage).
Example
Table 8.3 Consistency score data – XP Power
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
|
Reported EPS (p) |
46.5 |
39.4 |
83.9 |
107.1 |
81.7 |
95.8 |
102.1 |
103.7 |
112.0 |
148.3 |
Normalised EPS (p) |
46.4 |
39.3 |
83.2 |
106.4 |
81.3 |
95.1 |
101.1 |
102.8 |
111.2 |
146.0 |
Dividend per share (DPS) (p) |
17.2 |
18.0 |
27.1 |
36.9 |
41.0 |
45.1 |
50.0 |
54.1 |
71.0 |
78.0 |
Revenue (£m) |
69.3 |
67.3 |
91.8 |
103.6 |
93.9 |
101.1 |
101.1 |
109.7 |
129.8 |
166.8 |
Table 8.3 shows the ten years of data required to calculate the consistency score for XP Power.
Reported EPS is positive over the ten years, which scores 10 points. A dividend was also paid every year, scoring an additional 10 points. Normalised EPS makes a new high in 2008, 2010, 2011, 2016 and 2017, scoring 5 points. DPS has progressively risen over the past ten years, scoring a further 10 points. Revenue made new highs in 2008, 2010, 2011, 2015, 2016 and 2017, scoring 6 points.
The consistency score is therefore 41 (= 10 + 10 + 5 + 10 + 6) or 82% (= 41 ÷ 50), indicating that XP Power is reliably profitable with some room to improve further.
The consistency score can also be calculated using two years of broker forecasts. Table 8.4 shows the data required to calculate the forward consistency score for XP Power. Reported EPS is positive over the ten years, including forecasts, scoring 10 points. A dividend is paid out every year, scoring an additional 10 points. Normalised EPS makes a new high in 2010, 2011, 2016, 2017, 2018 and 2019, scoring 6 points. DPS rises every year, scoring a further 10 points. Revenue made new highs in 2010, 2011, 2015, 2016, 2017, 2018 and 2019, scoring 7 points.
The consistency score is therefore 43 (= 10 + 10 + 6 + 10 + 7) or 86% (= 43 ÷ 50). XP Power’s ability to reliably grow and be profitable is expected to improve over 2018 and 2019, as the prospective currency score of 86% is higher than the current consistency score of 82%.
Table 8.4 Consistency score with broker forecasts – XP Power
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
2018 (f) |
2019 (f) |
|
Reported EPS (p) |
83.9 |
107.1 |
81.7 |
95.8 |
102.1 |
103.7 |
112.0 |
148.3 |
167.2 |
193.6 |
Normalised EPS (p) |
83.2 |
106.4 |
81.3 |
95.1 |
101.1 |
102.8 |
111.2 |
146.0 |
176.0 |
189.5 |
Dividend per share (DPS) (p) |
27.1 |
36.9 |
41.0 |
45.1 |
50.0 |
54.1 |
71.0 |
78.0 |
82.5 |
87.5 |
Sales (£m) |
91.8 |
103.6 |
93.9 |
101.1 |
101.1 |
109.7 |
129.8 |
166.8 |
199.0 |
212.8 |
(f) indicates broker forecasts, taken at December 2018.
Relative strength
Growth companies with strong fundamentals should be performing better than the market average. This is a sign that the market is starting to appreciate the qualities of the company. You therefore want to ensure that share price appreciation for growth companies is strong relative to rises in a benchmark market price index. (For the UK, the benchmark is typically the FTSE All Share index.)
Positive relative strength highlights shares that have recently been performing better than the market benchmark. For growth companies, you should require the three- and 12-month relative strengths to be positive, with the 12-month strength being greater than the three-month. This indicates that the share price is still growing strongly relative to the overall market, but that the share price is not running ahead too quickly. Positive one-month relative strength is a bonus.
Example
Table 8.5 shows the relative strength of growth for Bloomsbury Publishing towards the end of December 2018.
Table 8.5 Relative strength – Bloomsbury Publishing
Relative Strength |
% |
1 Month |
2.3 |
3 Months |
5.3 |
1 Year |
23.5 |
The share price has been rising relative to the market, with relative strength being positive over one, three and 12 months. Relative strength over three months was 5.3%, compared with 23.5% over the past year. This suggests there is positive relative strength and that there is room for this to continue.
Summary
Companies with a competitive advantage will normally exhibit strong financial numbers. Look for:
· Five-year average and current ROCE and ROE above 10% for income and value companies, and above 15% for growth companies.
· Trend in ROCE and ROE is stable or is on a gradually rising trend.
· High current and five-year average operating margins that exceed 20%.
· Consistency score of 80% or higher.
· For growth companies, relative price strength is positive for three and 12 months; 12-month strength is greater than three-month strength.