Evaluating Stocks Using Profitability Ratios
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Whether investing money in common stocks, preferred stocks, or an entire business, you'll certainly want to assess the company's operations. Nowadays, many investors tend to speculate on high-flying growth stocks based on the potential to produce earnings in the long-run. However, I'm a strong believer in seeking maximum return while also keeping risk at bay. The company has to at least be profitable first! A company with a solid operating history and strong competitive advantage will tell us a good portion of the story! So, conducting solid investment analysis in this regard gives significant insight and confidence on the future outlook of business performance.
Two Classes of Profitability Ratios
There should naturally be a great deal of attention paid to the profitability of a company. In the many approaches of how to evaluate a company, conducting analysis using profitability ratios is very effective.
There are 3 primary financial statements that all companies use for reporting: income statement, balance sheet, and statement of cash flows. On one hand, profit margins are created with a comparison of profit (gross profit and/or net profit) to a company's revenues, giving a good indication of how expenses are being managed. On the other hand, another set of profitability ratios compares metrics from the income statement (typically profit) to figures on the balance sheet. This allows for analysis of management's efficiency in producing profits given the assets or capital at their disposal.
Return on Assets (ROA)
The return on assets ratio divides net profits by the total amount of assets on the balance sheet. The higher, the better! You'll want to look at it over time as well (i.e., the last 5 or 10 years) to determine a favorable trend. Companies with a strong balance sheet (i.e., lower collection periods of accounts receivable, efficient inventory turnover, etc) can reflect higher ROA, but of course the level of net profits is especially impactful. This metric will also vary by industry since some industries require far more assets than others. As such, ROA levels should be compared to that of other companies in the same industry.
Return on Equity (ROE)
The return on equity ratio divides net profits by the total amount of equity (aka book value or total assets minus total liabilities) on the balance sheet. For this metric, too - the higher, the better! It can be improved by increasing net profits, but it also can be improved with share repurchases or increasing the use of debt. And a company operating with too much debt can be pretty risky. Comparisons across time and to other companies within the industry should also be made.
High rates of ROE can reflect the presence of a competitive advantage with a company, especially if that high rate of ROE is consistent! If it's consistent, then the competitive advantage is likely strong and durable. The average return on equity for a U.S. company over the past 60 years has been about 12%. And, of course, as investors we're always aiming for above-average, so an ROE above 12% for a company is worthy analyzing further for possible investment.
Again, a consistently high trending ROE is likely indicative of a competitive advantage. Either the company is in a strong market position allowing it to charge a price premium or it produces its products more efficiently, or both. But if a company with a competitive advantage experiences a hiccup in earnings stemming from a industry recession or a one-off issue, the ROE will drop significantly. In turn, the market will likely overreact causing the per share price of the company to fall. If the fundamentals still remain strong, such an instance would certainly signal a buying opportunity! Take advantage of the market's shortsightedness.
Return on Invested Capital (ROIC)
ROIC is another, similar such ratio that is very effective in evaluating profitability and management efficiency. In contrast to ROE, the denominator in the formula also should take into account long-term debt. It takes into account not only management's use of equity but also how efficiently its using corporate debt. Evaluation of this ratio also helps to ensure ROE isn't high only as a result of using too much debt.
As with ROE, consistently high returns on invested capital are also indicative of a durable competitive advantage. ROIC is driven by competitive advantage, industry structure, and competitive behavior. Companies with high ROIC tend to be in attractive industries with unique products or services that can command price premiums. On the other hand, companies with low ROIC typically have undifferentiated products with many substitute products available.
Any investment is worth considering in full. You want to invest money to make money. And doing the homework upfront will allow you to minimize risk and rest easy knowing that your money is working for you well over the long-term. Use profitability ratios to effectively evaluate money investments in companies. These metrics are oftentimes cited in the summary or profile of the companies on investment sites. But they can also be easily calculated and modified for improvement by extracting figures straight from company balance sheets. Doing so will help to assess the quality of the company to determine whether it has a durable competitive advantage, as well as the quality of the management running the company.
The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.