How to find the most profitable companies in the market

What he meant was that investors should be prepared to pay a higher price for a slice of a good quality company. In defining Buffett's definition of quality, few would argue that a wonderful company is one that shows strong, consistent profitability.

After all, profitable companies are those that are likely to have the best chances of protecting themselves through the economic cycle. They often have robust brands and strong customer loyalty. And they are able to operate and grow very efficiently, which enables them to drive and compound shareholder returns over the long term.

Become a profit hunter

After a strong start to the year, the FTSE 350 index of the UK's leading shares has pulled back in recent weeks. For investors looking for potentially good quality shares at fair prices, these kinds of dips can offer buying opportunities for what are often expensive shares.

Yet in the pursuit of profitable companies, it is important to tread carefully. Headline profitability figures can be eye-catching, but companies are adept at presenting their financial results in the best light. So a checklist of profitability measures can be a useful way of getting to the facts.

A quality checklist

One of the most popular measures of profitability is to look at how much bang a company gets from the pounds it invests in itself. This is called return on capital employed - or ROCE (pronounced rocky). A high return on capital can be a signpost to stocks with strong and defensible brands and franchises that can be rolled out very profitably.

Another signpost to strong profitability is the percentage that a company keeps from selling its products after all costs have been deducted. This is known as the operating margin. High margins are often a hallmark of companies that can command high prices from their customers and have strong competitive advantages.

Competitive advantage is also something that can be examined by looking at what's known as return on equity. This is the technical term for comparing a company's net income to all the cash that investors have put into it. It's a popular way of comparing the profitability of companies in the same sector. ROE varies from industry-to-industry, but 15% is generally thought to be desirable.

A final check in the hunt for profitability is a ratio called free cash flow to sales. Despite sounding complicated, this handy comparison lifts the lid on the proportion of sales revenues that actually turn into cash after everything else has been paid. Companies are sometimes criticised for producing impressive-looking accounts yet fail to generate hard cash. This cash flow ratio should help you spot them.

With these profitability checks in mind, Stockopedia - the rules-based stockmarket investing website - created a screen of some of the most profitable companies in the FTSE 350 for our sister website Interactive Investor. It also includes Stockopedia's broad-based assessment of a firm's quality, called the QualityRank, which scores and ranks all companies in the market according to their financial and business strength - from zero (low) to 100 (high).

On many of these measures, online property marketplace Rightmove is one of the most profitable companies in the FTSE 350. Its brand dominance had led to consistent and very profitable growth in advertising sales, which has culminated in very high margins and returns on capital employed. It's a similar story at betting exchange and gaming operator Betfair, which is another online business that has been able to forge a strong and very profitable brand.

Investment supermarket Hargreaves Lansdown is also among the most profitable companies in the FTSE 350. Hargreaves has established a dominant name in the market that has allowed it to drive earnings growth very efficiently.

Interestingly, there are a number of high street names here, including WH Smith, Domino's Pizza, Next and Dunelm. These are companies that consumers identify with and have been able to roll out successful retail formats very profitably. The power of a dominant or unique market position can also be seen in the strong financial indicators at the likes of manufacturing company Howden Joinery, payment processor PayPoint and broadcaster ITV.

Over the past 12 months, this portfolio of the market's most profitable companies would have returned 45.3%, compared to 15.8% and 0.7% from the FTSE 250 and FTSE 100 respectively. But it's worth remembering that good quality, highly profitable companies are often fully priced in the market. A buyer like Warren Buffett would be waiting for market dips or temporary setbacks before pouncing. But from a broader perspective, the key factor here is that investors should know where to look for the signs of quality. In the hunt for wonderful companies it pays to check that profits really are what they seem.

Name ROCE% Op Mgn ROE% FCF/Sales % Quality rank
Rightmove 4,609 73.1 1,693 64.1 95
Betfair 143.5 21.1 78.3 26.4 88
Hargreaves Lansdown 108.9 51.9 87.9 34.7 83
WH Smith 67.4 10.4 81.0 7.94 92
Domino's Pizza 62.9 18.5 60.6 18.2 99
Next 59.1 20.6 244.3 15.8 99
Dunelm 46.6 15.5 46.1 7.58 82
Howden Joinery 42.1 17.4 63.9 10.5 99
PayPoint 41.8 22.1 35.7 15.9 89
ITV 38.0 24.0 49.8 18.2 85