How to Make Sense of a Company's Profitability Ratios
When getting to grips with interpreting a company report, you can test a company’s stock market reputation and money-making prowess using the following important formulas.
Price/earnings ratio compares the price of a share to earnings per share. A ratio of 10 means that for every £1 in company earnings per share, people are willing to pay £10 per share to buy shares in the company.
Price/earnings ratio = Share price Earnings per share
Dividend cover shows the number of times profits ‘cover’ the dividend. So, if profits were 100 and the dividend payment was 25 then dividend cover would be 4 times. Use it to determine whether a company is paying out earnings as opposed to retaining them in the business to fund growth. You can also see how likely it is that the company will be able to maintain its dividend strategy in the future.
Dividend cover = (Earnings per share) (Annual dividends per share)
Return on sales tests how efficiently a company is running its operations by measuring the profit produced per pound of sales.
Return on sales = Profit before taxation sales
Return on assets shows you how well a company uses its assets. A high return on assets usually means the company is managing its assets well.
Return on assets = Profit for the year Total assets
Return on equity measures how well a company earned money for its investors.
Return on equity = Profit for the year Shareholders’ equity
The gross margin gives you a picture of how much revenue is left after all the direct costs of producing and selling the product have been subtracted.
Gross margin = Gross profit Sales or revenues
The operating margin looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product.
Operating margin = Operating profit Sales or revenues