According to Novy-Marx, we can use two simple line items from financial statements to aid us in our search for high quality businesses. One comes from the income statement and one from the balance sheet. Interestingly, Marx uses Gross profitability instead of the traditional EBIT, or NOPAT metric(s). Marx calls it the Gross profit to total assets ratio. Defined as:
GPA = (Revenue - COGS)/Total Assets
Marx argues that Gross Profitability is the "cleanest" measure of underlying economic profitability. He continues:
"The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability. For example, a firm that has both lower production cots and higher sales than its competitors is unambiguously more profitable. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales through aggressive advertising or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income blow that of a less profitable competitor. Similarly, if the firm spends on R&D to further increase its production advantage, or invests in organizational capital that will maintain its competitive advantage, these actions result in lower current earnings. Moreover, capital expenditures that directly increase the scale of the firm's operations further reduces its free cash flows relative to its competitors. These facts suggest constructing the empirical proxy for productivity using gross profits."
I've used this ratio for the stocks not only that i hold but for the ones that are on my radar. One of the companies stands out from the pact, which is somewhat surprising.
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