When numbers can lie

Investors need to look beyond the financial metrics to identify a high-quality business

- JAMES CARLISLE

When tasked with finding a quality business, people often start by reaching for the numbers – typically things like margins and returns on equity. But these metrics can only provide a snapshot, are open to distortion and are necessarily backwards looking.

A few years back Woolworths got into the habit of measuring its success by reference to its margins. So, it kept pushing them higher until the earnings before interest and tax (EBIT) margin in its Australian supermarkets business reached more than 7% in 2015.

By that measure it was the best supermarket business in the world; but it pushed things too far, and in 2016 had to cut prices and improve service. The margin slumped back below 5%.

Another problem with margins is that they measure the wrong thing. What ultimately matters is the return a business makes on the money that’s sunk into it. Margins can only provide hints about that.

Key points to consider are:

• Start by analysing the business

• Examine product, competition, management and culture.

• Then cross-check with financials.

Some businesses make a huge amount of sales for each dollar of capital they use, so they can turn relatively thin margins into very thick returns on capital, which is where Woolworths really shines.

The return a business makes on its capital at least measures the right thing, but it’s open to its own confusions.

To address this, many use return on equity (ROE), which measures (usually post-tax) profit as a percent- age of a business’s net assets (ideally as an average over the year).