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How to check the quality of a stock’s profits

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Many investors believe that all profits are created equal. That is simply not the case. 

By analysing and digging deeper into the profit, we can see exactly where it comes from and how it is converted into profit. 

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While £1,000 of profit will always be £1,000 of profit, there can be important differences in the quality of that profit. And the quality of the profit can have a significant impact on the quality of a portfolio, making the difference between a successful investment that continues to grow in value and a short-lived investing regret.

Let’s take a look at how to check the quality of a company’s profits.

Identify what type of revenue the profit comes from

When checking the quality of a company’s profits we need to look out the sources of that profit. There is a big difference between one-off sales and recurring revenue.

For example, a company may have single large orders every few years at random, or it could have a steady and increasing level of orders every year. We can be much more confident investing in a company with regular and growing business, than in one that gets big orders, but few and far between.

Furthermore, if the company is able to lock its customers into a subscription model, in which premiums are paid on a recurring basis, then we can be even more confident of the revenue being secured.

Single customer risk

Which company would you rather invest in: a company with lots of customers, or a company that has a single customer that makes up a large portion of its revenue?

The latter company stands to lose a lot more if that single customer runs into trouble or decides to pull the plug on its orders. A company that has a broad and diversified client base does not need to worry so much. 

The quality of the customer

This is another factor that we should focus on. Customers who are small and growing, who aren’t able to finance their own operations from funds generated internally from the business, should be classed as a much higher risk than a company that is established and more mature. 

While the growing company may end up increasing its order rate year on year, if the business is dependent on further cash injections, then there is a risk that the available credit and funding eventually dries up leading to a collapse. 

Focusing on the quality of the customers of the companies that you invest in can have a big impact on the quality of the profits that your investments generate. 

Clearly, not all profits are created equal. By looking at the type of revenue, how the revenue is split among the company’s clients, and the quality of the customers themselves, we can learn a lot about the quality of a company’s profits. 

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Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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