Profitability Ratios for Investment Analysis - dummies

Profitability Ratios for Investment Analysis

By Peter J. Sander, Janet Haley

Profitability ratios form a core set of bottom-line ratios crucial to all investment analysis. Profitability ratios are typically based on net earnings, but variations will occasionally use cash flow or operating earnings.

Typically, items related to extraordinary charges or discontinued operations should be excluded when calculating these ratios. If you’re using figures from a financial portal or calculations from a screener or other financial information package, check to make sure that figures exclude extraordinary items. You may have to dig into the company’s own issued financial statements.

Return on sales

This ratio is just as it sounds:

Return on sales = net earnings / sales

Return on sales (ROS) tells you how much profit a firm generated per dollar of sales. This figure is better known as the net profit margin. Closely related is gross margin:

Gross margin = (sales – cost of goods sold) / sales

Obviously, gross margin is a key driver of return on sales and is the most strongly connected to the organization’s business strength and operational effectiveness. Some analysts also look at operating margin:

Operating margin = (sales – cost of goods sold – operating expenses) / sales

where SG&A (selling, general, and administrative) expenses, marketing, and asset recovery (depreciation) and special amortizations are factored in.

Return on assets

How much profit is generated per resource dollar invested? Return on assets, or ROA, provides the answer:

Return on assets = net earnings / total assets

This measure is especially important in asset-intensive industries, such as retail, semiconductor manufacturing, and basic manufacturing.

Return on equity

Return on equity, or ROE, is one of the more important bottom-line ratios in the value investor’s repertoire.:

Return on equity (ROE) = net earnings / owner’s equity

ROE is the true measure of how much a company returns to its owners, the shareholders. It is the bottom-line result of other factors, including asset productivity, financial structure, and top-line profitability. ROE is important as an opportunity benchmark. What else could an investor invest in to get a better return? Again, consistency, trends, and comparisons are critical.

Return on invested capital

Debt, while raising ROE in good times, also can lead to financial disaster. As a result, many investors instead look at return on invested capital (ROIC), measuring profit as a percentage of combined owner’s equity and debt investments. This measure is sometimes called return on total capital, or “ROTC”:

Return on invested capital (ROIC) = net earnings / (owner’s equity + long-term debt)

Frequently, you see ROE and ROIC side by side in ratio charts and discussions. Sustained ROE of 20 percent or more is considered very good. ROIC will be lower, because now debt is included in the denominator. But for many investors, it is a truer measure of how much the company is really earning per capital dollar invested.