What You Should Know about Performance Ratios and Penny Stocks - dummies

What You Should Know about Performance Ratios and Penny Stocks

By Peter Leeds

Also known as profit margins, performance ratios display exactly how much money a penny stock company is making at each stage of its operations. The amounts are illustrated as percentages.

Profit margins are often very small and can improve very slowly. This is generally due to the following factors:

  • Fulfillment costs: To provide any product or service, there will always be certain costs — which is why you will never see a profit margin of 100 percent. Profit margins of 5 percent, or even less, are not unusual.

  • Costs of supplies: The prices of many commodities or supplies required to build a product can often change.

  • Currency fluctuations: Many companies make or spend money in more than one country and so are exposed to fluctuations in the prices of currencies.

  • Competition: Battling for customers and market share can be very expensive.

Even a small improvement in a profit margin can have significant ramifications on a company’s results. Bringing an operating profit up from 6 percent to 10 percent can represent millions of dollars in additional earnings.

Gross profit margin

Gross profit margin illustrates the profitability, and therefore the viability, of a company selling its products or services. The measure is of major importance because the first step for any company is to sell its wares at a profit.

Here’s the ratio:


Gross profit margin is expressed as a percentage. For example, a gross margin of 20 percent means that for every dollar in sales, a company spends 80¢ to produce the product and sell it while taking in 20¢ as profit.

When a company has no revenues or is actually selling at a loss, it will have a negative, or nonapplicable, gross profit margin.

The gross profit margin ratio is very industry specific. Here are some examples of companies that typically have gross profit margins that are

  • High (above 70 percent): Internet hosting, online subscriptions, software, digital files, and computer storage

  • Medium (near 30 to 50 percent): Jewelry retailers, clothing, specialty stores, golf supply, and pet stores

  • Low (less than 15 percent): Mass market retailers, fast food, movie theaters, farming, electronics stores, and airlines

Gross profit margin is of tremendous use for comparisons against competition in the same industry.

With this ratio, higher numbers are better.

Operating profit margin

A company has many more expenses than those it incurs to produce and sell products. For example, it has administrative expenses, rent, and overhead. To take these costs into account, look at a company’s operating profit margin.

This ratio is where you will see improvements by companies looking to control their costs. Operating income is generated after taking all expenses into account, with the exception of interest and taxes.

By dividing EBIT (earnings before interest and taxes) into total revenues, you calculate the operating profit margin, which is expressed as follows:


Operating profit margin offers a more accurate view of a company’s profitability than gross margin and demonstrates if a company is truly viable. A business may have an 80 percent gross margin, but after it pays for electricity and administration, does it have anything left? To find out, turn to the operating profit margin.

When looking at operating profit margin, higher numbers are better. But because this ratio factors in additional expenses beyond the cost of goods sold, the operating profit margin will always be lower than the gross margin.

Net profit margin

To determine a company’s net profit you subtract all the company’s costs — costs to produce and sell the products, and the administrative and overhead expenses — from total revenues.

Net profit is the money earned (or lost) after taking every cost into account, with a few exceptions. Specifically, values for interest, taxes, depreciation, and amortization are not included in net profit. Net profit is often referred to as EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization.

Also called earnings, net profit is what can really move a share price because it represents a company’s final result after all factors and expenses are considered.

The net profit margin is derived from dividing the net income by the total revenue. It shows how much profit was generated from total sales. Here’s the equation:


A company with $1 million in net profit from $5 million in sales has a net profit margin of 20 percent. That same company, but with $50 million in sales, has a ratio value of only 2 percent ($1 million profit divided by $50 million sales = 2 percent).

Because this financial ratio takes all expenses into account, it is lower than the gross margin and lower again in comparison with the operating margin.

Look at the direct competitors of all sizes to gain insights into the strength or weakness of the net margins for any penny stock.

Return on assets

The return on assets explores the amount of earnings generated from the total asset position of a company. The equation is as follows:


The higher the ratio, the better. A corporation may report $1 million in earnings compared to $50 million in assets, for a return on assets of 2 percent (1 divided by 50). What would be even better is if they achieved $1 million in earnings from a smaller asset base, such as $8 million. In that case, the return on assets would be 12.5 percent (1 divided by 8).

With penny stocks, return on assets is sometimes a useful analysis tool, but not in the majority of situations. Newer and lower-priced companies often don’t have either earnings or assets of any significant amount.

Return on equity

The return on equity ratio measures how much profit the corporation has generated from the money shareholders have invested. Here’s the formula:


Higher ratios are desirable, but this ratio is of limited value for evaluating penny stocks. Most start-ups and newer corporations have a large equity position and low or nonexistent profits.