How do you know when you have a stock on your hands that can deliver major long-term returns? You know, the kind of returns that stocks like Apple and Microsoft have delivered year after year for a decade or more…

In other words, there must be something that separates these stocks from the pack. Something that we can look for to determine whether a stock is a potential long-term winner…

The simple answer: profitability.

After all, more company profits lead to greater earnings for shareholders. This cash can also finance acquisitions or expansion into new markets. Mature companies can also use it to pay out higher dividends or buy back stock. The list goes on…

Keeping an eye on profitability metrics is important, because it’s a sign of a company with strong competitive advantages. In other words, companies with consistently high margins tend to sport high market share and attractive business models. These are just the sort of companies that could become the next big long-term winner — the “next” Microsoft.

Why Profitability Matters

The reason a company’s dominance translates into profitability is simple. When several rivals battle it out in a market, they usually compete with one another on price. This, of course, eats into profitability.

Companies in competitive markets often spend heavily on advertising and new product design to differentiate from the competition. The falling prices obviously cut earnings and margins, while rising marketing costs can eat into profits. In a worst-case scenario, the company’s very own product can become commoditized.

To understand why that’s not good news for a long-term investor, just look at the commodity sector. Companies dealing with commodities sport some of the weakest profit margins you’ll find. After all, steel, gold, or wheat can’t be differentiated. Temporary shortages can certainly cause a spike in prices and industry profit margins. But they rarely last long.

By contrast, a highly profitable company usually operates in a market with few real competitors.

Metrics For Understanding Profitability

There are many ways to measure profitability. And in their own way, they help us arrive at an answer to a very basic question: out of every dollar of sales, how much does a company keep as profit?

Here are some of the profitability metrics that our analysts watch closest:

Net Profit Margin — This is one of the most basic measures of profitability. It tells us how much of every dollar taken in becomes profit. We calculate it by dividing a company’s total net profit by total revenue. The number is expressed in percentage terms.

Operating Margin — Simply divide operating profits by total revenue to get a company’s operating margin.

Net profit margins are often skewed by one-time events such as the sale of real estate or gains on investments that aren’t part of a company’s normal business. However, by looking at operating margins, investors reduce this problem.

Cash Flow Yield — Cash flow yields are calculated by dividing a firm’s total cash flow by total sales. (For the same reasons outlined above, analysts will often substitute operating cash flow in this calculation.)

This ratio measures how much cash a company generates out of each dollar of sales. Because accounting profits often include many non-cash charges and payments, net income doesn’t necessarily reflect how much a company is making from normal operations. Furthermore, larger companies routinely use accounting gimmicks and tricks to dress up their numbers for Wall Street. Cash flow data measures the actual flow of money. It’s difficult to fudge this metric, so it often provides a more accurate picture of a company’s underlying profitability.

Free Cash Flow Yield — This measure is like the cash flow yield, except free cash flow is substituted for cash flow. Free cash flow is left over after interest, taxes, dividends, and capital investments. Basically, free cash flow represents the excess cash a company does not need to meet financial obligations or invest in future growth. This makes its a more accurate measure of the actual cash available to shareholders.

Return on Equity (ROE) — Calculated by taking a company’s net income and dividing that figure by total shareholder equity — one of the favorite metrics of billionaire investor Warren Buffett. Because shareholder equity is a rough measure of how much stockholders have invested in a firm, this ratio tells us how much money a company makes in relation to shareholders’ collective investment.

Bringing It All Together

You can find this information on most major financial websites, or in a company’s quarterly filings.

Understand that none of the metrics shown above are perfect. To get a full picture of a company’s profitability, the best course of action is to use a mixture of these metrics. These different metrics all provide answers to different questions related to profitability.

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