Quality and returns

This course is about whether a business is a good one, in the narrow sense that can be settled from filed accounts. Eight lessons, in an order that is an argument rather than a list.

The first three are the margins, in the order the income statement subtracts them. Each makes a different case. Gross margin is about a line drawn by policy, and it is the margin that is mostly about the product rather than about the company. Operating margin is about a line drawn by the company's own discretion over what counts as operating, and about a ratio that swings violently with volume while nobody decides anything. Net margin is about the claims other parties have on the profit: the tax authority, the lenders, and the owners of the part of a subsidiary the company consolidates in full.

The next three are the returns on capital, which need the balance sheet as well as the income statement. They run in the order in which each removes a defect from the one before. Return on assets divides a return belonging to shareholders by a capital base belonging to shareholders and lenders together. Return on equity repairs that and introduces a worse problem, because borrowing and buybacks both raise it with nothing earned. Return on invested capital repairs both and pays for it with the widest legitimate disagreement in the course about how its denominator is built.

The seventh lesson could not have been read before the sixth. An average return on capital is a fact about every dollar the business has ever employed, and the rate it earns on the money it puts in this year is a different number that the average conceals for as long as the old capital dominates the base. That argument only lands once the average version is understood, which is why the incremental return comes after it rather than inside it.

The last lesson is the compound growth rate. It sits here rather than in a course of its own because a growth rate with no return on capital beside it does not say whether the growth was worth having, and the lesson before it is the one that answers that question.

None of these lessons names a level at which a figure becomes good. For the margins no such level exists across industries. For the returns the comparison that matters is against a cost of capital, which is a different course. What this course prints instead is measured distributions, each carrying the date it was computed, the size of the cohort, and who was excluded from it and why.

Where this sits

Fourth of nine courses. It needs all three before it: the first for where the numerator and denominator are read from, the second because the largest distortion of every return here is an accounting choice, and the third because it settled what counts as capital. Cost of capital follows, and supplies the figure these returns have to beat.