As investors we want to own shares in companies that become more valuable over time. But what makes one company more valuable than another? A company’s value is equal to the future earnings. This means a company’s value is most likely to be affected by:

  • How much of its product or service the company can sell (revenue)

  • How much of that revenue the company can keep (profits)

  • What returns, in the form of future profits, the company can get on money they invest back into the business (returns on invested capital)

A company that can grow revenue faster, keep more of that revenue as profits, and get higher returns on their investments in the business is more valuable than a company that cannot. But the essence of capitalism means that situations like this are rare.

If a company or sector is seeing high levels of growth or profitability, other companies will want a slice. And if there is nothing to protect the companies already profiting, this influx of competition will drive excess returns over the cost of capital in the sector towards zero.

If a company can defy capitalism and achieve high profits and returns on capital for a long time, there is likely a structural reason for it. At Morningstar we call this a moat. Not all companies with high profit margins have moats, and not all moated companies have high profit margins. But their presence for a long time is a clue worth following.

High margins also make it easier for a firm to achieve better returns on investments it makes in its business. This becomes clear when you break down common ratios used to measure these returns. As an example, a company's return on equity is calculated as follows:

Return on equity = Net Profit Margin (net profit after tax/revenue) x Asset Turnover (revenue/total assets) x Leverage (total assets/shareholders equity)

The higher a company’s net profit margin, the less weight falls on the other components to deliver good returns for shareholders.

Today we’re going to look at three ASX shares that have enjoyed high profit margins for several years. What’s more, the shares all trade below our analysts’ estimates of fair value. Before we get onto the shares, let’s look at the three main types of profit.

The three main measures of profit

Gross Profit is revenue minus the direct costs of producing the goods or providing the services being sold. Direct costs will include the cost of materials and labour used to produce the goods being sold or costs necessary to provide a service. There may also be a charge to represent past investments made in things like machinery and software, which will show up as a depreciation or amortization charge. If a firm sells software, gross profit can be a good portion of the firm’s revenue because limited material and labour costs can be assigned to the product itself. What constitutes a direct cost is debatable and companies will often include different costs here. As a result, comparing the gross profitability of two firms can be problematic.

Operating Profit takes gross profit and subtracts other costs involved in a company’s core operations. Key here are costs incurred in selling the product or service (like salesperson salaries, rent costs, marketing and admin). There may also be additional depreciation and amortization charges related to buildings, equipment and software bought previously. Operating profits are a cleaner way to compare two companies because there is less flexibility for what costs are included– it represents everything bar interest, tax and non-operating costs. As a result, it also cuts out the effects of different financial structures and tax rates.

Net Profit takes operating profit and subtracts or adds the following: interest expenses or income, estimated tax payments and non-operating costs or profits – for example from a minority equity investment.

Dividing the gross, operating or net profit by revenue will give you a profit margin expressed as a percentage. Because more costs are included each time, the margin will normally get lower as you work your way down. Here are PepsiCo’s gross, operating and net profit margins for the last three full years:

pepsi-margins

Today we are most interested in net margins, the percentage of revenue these ASX companies have historically kept as profit after all costs are considered.

Three cheap ASX shares with high net profit margins

ASX Ltd ★★★★

5-year average net profit margin: 47%
Moat rating: Wide

ASX Ltd (ASX: ASX) is Australia’s leading provider of equity listings, settlement, clearing and trading. It has an effective monopoly on equity listings in Australia with over 95% market share. ASX’s catchment zone also extends to New Zealand, with New Zealand based companies cross listing on the ASX equating to around a third of total companies listed on the New Zealand Stock Exchange.

ASX’s profit margins are off the charts. ASX gets most of its revenue from clearing and settlement services. It also sells data generated by activity on their own exchanges. With essentially no cost of goods sold, its 5-year average gross margin is 100%. As for operating costs, ASX is a high fixed cost business that has reached huge scale. It takes the same basic infrastructure and software to clear one trade as it takes to clear two (or two thousand) trades. This is reflected in a 5-year average operating margin of 66%. As ASX has no debt, interest expenses aren’t a factor and tax is the only major deduction. ASX has a 5-year average net margin of 47% and has achieved similar levels of profitability for many years.

The question is whether ASX’s ability to generate outsized profits can persist. Morningstar's ASX analyst Roy Van Keulen has given ASX a Wide Moat rating due to network effects in its settlement, trading and clearing businesses. A network effect is where a company’s products and services are improved by every additional user. This generally eventually leads to a winner-takes-most competitive environment. In ASX’s case, higher trading volume leads to better liquidity, lower costs and tighter bid-ask spreads for traders. Van Keulen also thinks that ASX benefits from these network effects in its technology and data business, which can offer products and services based on proprietary data generated by ASX markets. As ASX provides much of Australia’s financial infrastructure, the firm’s activities are heavily regulated. This limits the company’s upside and downside potential.

ASX has long been protected from competition through exclusive licenses to clearing and settlement. However, ASX’s decision to shelve long-promised upgrades to its settlement system have led to concerns that regulators will seek greater competition. Van Keulen thinks the chances of this are reduced by the fact that equity settlements and clearing are hardly hot-button issues for most of the Australian electorate. He thinks it is more likely that the Australian financial system continues to consolidate around ASX due to its monopoly-like market share and the network effects mentioned earlier.

Van Keulen think ASX has a Fair Value of $75 per share. This is based on revenue growth assumptions of 6% per year for the next decade and higher profit margins as investments in the clearing upgrade wind down. On the revenue side, he thinks ASX could benefit from increased trading and hedging volumes if market volatility continues because of changing interest rates and geopolitical tensions. This is especially relevant to materials and energy companies, which make up most of the companies listed on ASX. While more volatility could impact the number of new listings, Van Keulen thinks the important role of metals and natural gas in the net zero transition could outweigh this and lead to listings growth.

CSL ★★★★

5-year average net profit margin: 21.4%
Moat rating: Narrow

CSL (ASX: CSL) is one of three Tier 1 plasma therapy companies that benefit from an oligopoly in a highly consolidated market. All the players are vertically integrated as plasma sourcing is a key constraint in production. The plasma sourcing market is currently in short supply, however, CSL is well positioned having invested significantly in plasma collection centers, owning roughly 30% of collection centers globally.

CSL and its fellow Tier 1 plasma companies Grifols and Takeda Pharmaceuticals have an estimated 80% market share and a cost advantage over smaller competitors. Gross margins of the Tier 1 trio are on average 20 percentage points higher than tier two players such as Octopharma. Much of this is driven by economies of scale that minimise the cost per liter to collect and process plasma. Processes such as purifying and testing are more efficient with higher volumes, as labor and overhead costs are leveraged. Vertical integration across the top 3 also reduces the need to purchase plasma on the open Tier 1 market. This allows CSL to achieve higher profit margins from selling their products at the same prices as smaller competitors. CSL’s average net margin for the past five years is 21.5%.

Our CSL analyst Shane Ponraj assigns CSL a narrow moat rating. This means he thinks CSL can continue to earn excess returns on capital for at least 10 years. His narrow moat rating stems from the cost advantages from CSL’s large-scale plasma collection and fractionation. Ponraj also thinks CSL’s returns are protected by intellectual capital and the proven success of its R&D efforts over time. The industry has high barriers to entry as plasma fractionation has long lead times, taking approximately seven years to be built and approved. Fractionation is also a complex process that requires significant expertise and scale to be performed cost-effectively.

Ponraj thinks CSL is worth $310 per share, based on an exchange rate of 0.65 USD per AUD and 9.0% average revenue growth over the next 5 years. He also thinks that CSL can expand its profit margins and grow earnings at an average of 13.5% per year over that time. His forecast includes five-year immunoglobulin market growth of 10% and CSL's share of the market increasing to 34% from 32% over this period.

Steadfast Group ★★★★

5-year average net profit margin: 14.9%
Moat rating: Narrow

Steadfast Group (ASX: SDF) operates the largest general insurance broker network in Australia and New Zealand. Steadfast has been consolidating the market since it was founded in 1996 by taking equity interests in brokerage businesses. It has deployed a similar strategy in underwriting agencies. It derives revenue by being paid a commission (from insurers) based on gross written premium written by agencies within its network, earning a share of profits from associates and joint ventures, and receiving professional services fees.

As a brokerage network, Steadfast’s revenue comes from commissions and there is therefore no cost of goods sold. This is reflected in Steadfast’s five-year average gross margin of 100%. Staffing costs are their biggest expense by some distance, and once other operating costs are deducted their five-year average operating margin comes out at 18.75%. For most businesses, net margins are lower than operating margins because of tax and interest costs. There is a less of an impact here for Steadfast because it earns interest income during the time between a customer pays their premium and Steadfast pays for the policy. Steadfast’s five-year average net margin is 14.9% but this is depressed by the loss they made in 2020 due to acquisition costs and asset write-downs.

Our analyst Nathan Zaia assigns Steadfast a narrow moat rating due to switching costs. There are two aspects to Steadfast’s switching cost advantage. First, the tangible benefits for clients to switch to an alternative broker are uncertain; and there are tangible risks or costs in moving from a broker who understands the specific business need (and can align those to a broad range of insurance offering), versus one who does not. For insurers, the underwriting intermediaries provide specific expertise in specialty lines, and in turn through Steadfast, access to a pool of customer demand. There is limited incentive for an insurer to switch underwriting agencies, provided risk is appropriately priced for the insurer. Second, there is an incentive for the brokers and underwriting agencies themselves to remain within the Steadfast network. Brokers benefit from an ability to offer policies which are more competitive or with better terms, the potential to earn higher commissions, as well as strong technological support. These benefits reflect Steadfast’s scale and leading position in the Australian intermediated general insurance market.

Zaia’s fair value estimate for Steadfast is $6.30 per share, incorporating higher insurance premiums, and as a result, higher broker commission, over the next five years. He thinks overall policies written by Australian brokers will grow by 6.5% per year until 2028 and that Steadfast’s commission structures should remain stable given their dominant market position. This allows the firm to push through higher volumes and negotiate higher commissions. He also sees the potential for further growth in the Steadfast network through acquisitions but at a slower pace as the industry’s consolidation matures.

Terms used in this article

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Further reading

Persistently high profit margins may be a sign of durable competitive advantage. We call this a moat. To learn about finding different sources of moat, read this article by Mark LaMonica.

If you'd like to learn more about network effects and two other Australian shares (besides ASX) that benefit from them, read my article 'These 3 ASX stocks share something powerful with Uber'.