Published by Nick McCullum on July 16th, 2017
The two main benefits of owning common shares of a publicly-traded corporation are:
- Your claim on earnings
- Your claim on assets
Accordingly, a company’s ability to use its assets to generate earnings is very important.
How do we measure this?
There are a number of financial metrics that investors use to measure a company’s profitability. These include:
- Gross Profit Margin
- Net Profit Margin
- Return on Assets
- Return on Equity
- Return on Invested Capital
All else being equal, higher profitability metrics should result in superior long-term total returns. This means that investing in highly profitable businesses has merits as part of a holistic investment strategy.
With that in mind, this article will compute rankings based on the five profitability metrics listed above using a group of the most high-quality businesses around – the Dividend Aristocrats.
Profitability By Gross Profit Margin
Gross margin measures the markup between the direct cost of delivering goods or services and the price it is sold for. It does not account for generalized business expenses such as salaries, interest, taxes, or office supplies. Gross margin is also called gross profit margin.
The equation for gross profit margin can be seen below.
Gross profit is defined as revenue minus the cost of goods sold. The exact implications of this definition will vary slightly depending on what type of business you are analyzing – a merchandising company, a services company, or some combination of the two.
For a merchandising company, gross profit is the difference between the price paid for a product when purchased from a supplier and the price the company sells it for to a customer.
Mathematically, gross profit is computed as:
Using this definition of gross profit, we can rewrite the original definition for gross profit margin as follows:
The nature of gross profit margin calculations suggests that companies with the highest product markups – think luxury merchandisers, bottled water, prescription drugs, etc. – should have the highest gross margins. Let’s see if the data supports this hypothesis.
Here are the 10 Dividend Aristocrats with the highest gross margins:
The Dividend Aristocrat with the highest net margin is T. Rowe Price Group (TROW).
T. Rowe Price is a global asset management firm with more than $800 billion in assets under management.
The asset management industry has very attractive economics because assets under management – their main source of revenue – has the capability to increase at a much faster pace than fixed expenses, which increases gross margin over time. This has likely helped T. Rowe Price’s ranking above.
AbbVie is a pharmaceutical company that manufactures and sells prescription drugs, most notably Humira, the highest-grossing drug in the world. Because of the high markups of prescription drugs, it is unsurprising that AbbVie has high gross margins.
Consolidated Edison is a regulated utility. The company buys energy and transports it to consumers. The high barriers to entry and regulatory scrutiny of Con Ed’s industry are two contributors to the company’s healthy gross margin.
Performing qualitative analysis on the remaining 7 companies in the table above reveals similar observations – there are noticeable characteristics about each business that help to generate high gross margins.
Profitability By Net Profit Margin
Net margin (sometimes called net profit margin) expresses – as a percentage – how much net income is generated for every dollar of revenue.
Net profit margin is calculated as follows:
Net margin is partially related to gross margin. A company with higher gross margin will have a higher net margin, assuming other expenses (such as salaries, insurance, tax, and interest) are held constant.
With that said, other expenses are never held constant. There may be considerable differences between the top 10 most profitable Dividend Aristocrats when using net profit margin versus gross profit margin. Because this difference is driven by non-cost-of-goods-sold expenses, I believe that companies with high operating expenses will be lower on this ranking (or perhaps removed from the top 10 completely).
Here are the 10 Dividend Aristocrats with the highest net margins:
S&P Global (SPGI) and Air Products & Chemicals (APD) are the top 2 Dividend Aristocrats by net profit margin. The top 3 is rounded out by T. Rowe Price, whose high net profit margin is certainly boosted by its high gross profit margin.
As before, a qualitative analysis of the top companies reveals the fundamental reasons behind their high profit margins.
S&P Global provides credit ratings, financial benchmarks, analytics, and data to global financial markets. The company is most well-known for creating and managing the popular equity benchmark the S&P 500 Index.
The reason for its high margins is simple: S&P Global operates a very capital-light business model. In addition, much of its services are technology-based (an industry that typically has very high profit margins). These are two contributing factors to S&P Global’s high margins.
The next high-ranking company is Air Products & Chemicals, a diversified industrial gases firm. The causes of this company’s high margins are two-fold.
First, Air Products & Chemicals benefits from tremendous economies of scale. As the largest global supplier of both hydrogen and helium, the company generates significant economies of scale, boosting margins.
Secondly, Air Products is an exceptionally well-managed enterprise (as are most Dividend Aristocrats). The company’s management team has an internal 10% rate of return target it must reasonably expect to achieve before initiating any new projects. This laser focus on building value boosts the company’s earnings, which drives profit margins upwards.
Just like with gross margin, a quick investigation of the fundamental driving forces behind the highest net profit margins within the Dividend Aristocrats reveals some insightful (but unsurprising) observations.
The next section turns to the balance sheet (instead of the income statement) for another measure of corporate profitability.
Profitability By Return on Assets
Return on assets expresses how well management is using a company’s assets to generate financial returns. Mathematically, return on assets expresses as a percentage the dollar amount of net income that is generated for each dollar of assets on a business’ balance sheet.
The equation to calculate return on assets is:
Because of the nature of how return on assets is calculated, companies that employ a lot of leverage (such as a bank) tend to have very low returns on assets, and companies that employ very little leverage will have higher returns on assets.
Case-in-point: compare the return on assets of Wells Fargo (WFC) – a bank – with Hormel Foods (HRL), a company with very little leverage:
- Wells Fargo 2016 Return on Assets: 1.1%
- Hormel Foods 2016 Return on Assets: 9.3%
Source: Value Line
With that in mind, let’s see which 10 Dividend Aristocrats have the highest returns on assets:
Two old favorites have the top positions in this list: S&P Global and T. Rowe Price Group.
Colgate-Palmolive (CL) is the Dividend Aristocrat with the third-highest return on assets.
Like Air Products & Chemicals before it, two main reasons why Colgate-Palmolive has high profitability metrics are its global size and scale combined with an exceptional management team focused on cost control.
Colgate-Palmolive also benefits from its considerable brand equity. Consumers are highly likely to buy Colgate toothpaste simply because it is the first oral care brand that comes to mind.
The next section turns to the Liabilities & Shareholders’ Equity section of the balance sheet for an additional corporate profitability metric by which to rank the Dividend Aristocrats.
Profitability By Return on Equity
Return on equity expresses as a percentage how much net income is generated for each dollar in shareholders’ equity.
Mathematically, return on equity is calculated as:
Shareholders’ equity is generated by paid-in capital (via share issuances) and retained earnings. Dividend payments subtract from shareholders’ equity.
While return on equity and return on assets have very similar calculations, there can be stark differences in the ROEs and ROAs of a particular business. The source of this discrepancy lies in the capital structure of the business in question.
Leverage reduces shareholders’ equity and increases return on equity, all else being equal. Because of this, highly-leverage companies like banks tend to have much higher returns on equity than returns on assets.
For instance, consider the return on equity and return on assets of Bank of America (BAC) in fiscal 2016:
- Bank of America 2016 Return on Assets: 0.8%
- Bank of America 2016 Return on Equity: 6.7%
Source: Value Line
Bank of America’s return on equity is nearly 10x as high as its return on assets, which shows the power that leverage has on the difference between these two financial metrics.
Moving on, here are the 10 Dividend Aristocrats with the highest returns on equity:
Kimberly-Clark (KMB) stands out as having a return on equity that is nearly four times as high as the second-highest Dividend Aristocrat.
Why is this?
It could be that Kimberly-Clark employs much more leverage than any other Dividend Aristocrat. This is indeed the case.
In fact, Kimberly-Clark actually held negative shareholders’ equity in recent years, which indicates that its liabilities exceeded its total assets.
Since Kimberly-Clark is just coming out of this period, its shareholders’ equity is still close to zero, resulting in the sky-high return on equity.
S&P Global’s highly profitable business model allows it to also rank well using return on equity.
The Dividend Aristocrat with the third-highest return on equity is Clorox (CLX). Clorox also ranked in the top 10 for return on assets but did not rank in the top 10 for the revenue-based metrics: gross profit margin and net profit margin.
These two facts observed together indicate that Clorox operates an asset-light business model, but still generates a large amount of revenue for each dollar of net income. Considering Clorox’s business model – a consumer products company that manufactures household cleaning and lifestyle products – this assumption appears sound.
Moving on, the next section discusses our last profitability metric, also based on balance sheet fundamentals.
Profitability by Return on Invested Capital
Return on invested capital is the most complicated profitability metric referenced in this analysis.
It measures a company’s ability to uses its invested capital to generate net income.
Based on the previous calculations of return on assets and return on equity, it is unsurprising to see that return on invested capital is calculated as:
The tricky part of calculating return on invested capital is not the top-level calculation of net income divided by invested capital. Instead, the difficult part is determining what to use for ‘Invested Capital’.
Invested capital is meant to show how much money has been contributed by shareholders and bondholders to a business. Shareholders’ equity and liabilities is an imperfect measure of this because it contains retained earnings over many years of business, as well as non-bond liabilities.
Instead, ‘Invested Capital’ is often calculated as follows:
Invested capital has a complicated calculation, but many value investors believe ROIC to be a strong measure of business quality. In fact, Joel Greenblatt uses a variation of the ROIC calculation shown above in his Magic Formula investment strategy (he uses EBIT divided by net fixed assets plus working capital).
With all this in mind, here are the 10 Dividend Aristocrats with the highest returns on invested capital:
Again, S&P Global and Colgate-Palmolive are strong performers as measured by return on invested capital.
The only new player in the top 3 most profitable Dividend Aristocrats is Sherwin-Williams (SHW).
Sherwin-Williams is North America’s largest producer of paints and varnishes. The company also manufactures accessory products such as paint application equipment and specialty coatings (such as automotive adhesives).
What stands out about Sherwin-Williams is its unique combination of industry-leading size and substantial brand recognition. Like Colgate-Palmolive, consumers are likely to purchase from Sherwin-Williams because it is a well-known, household brand name.
This article analyzed the top 10 most profitable Dividend Aristocrats based on a number of important profitability metrics:
- Gross Profit Margin
- Net Profit Margin
- Return on Assets
- Return on Equity
- Return on Invested Capital
Interestingly, there was a moderate amount of consistency between the companies in the top 10 for each metric. There are two observations that can be made from this:
- These profitability metrics are sufficiently related as to create some consistency between their top performers.
- There is still benefit to using multiple profitability metrics in a holistic investment strategy.
Also, investors should keep in mind the types of companies that had outstanding profitability metrics.
Capital-light businesses like S&P Global or T. Rowe Price generate high levels of net income from low asset bases.
Similarly, outstanding brands like Colgate-Palmolive or Sherwin-Williams are capable of marking up their brands – and increasing profit – without losing market share.
These observations can help you to find your next high-quality dividend investment.