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Profitability Ratios: A Business Approach to Investing

Business and investing go hand and hand. Often the best investors are also really great businessmen. Just look at the sharks on the famous TV show Shark Tank. They are all successful business people, and now putting their money to work as investors.

Even a great investor like Warren Buffett has said that intelligent investing is buying a stock as if you are purchasing the business. The same profitability ratios learned in business school can be invaluable in helping you to find great investments. Many of these formulas do crossover to both arenas, which is why learning them is so important.

profitability ratios

The problem with most of the profitability ratio information out there is that the application is not easily apparent. Information is just thrown at you, with the expectation that you will somehow absorb it. That’s not what I’m about, or what this website is about. No, I’m all about teaching you the information so you can not only learn from it, but profit from it too.

That’s why this post will give you actionable links with each of these metrics, so that you instantly have the power to sort between thousands of stocks and businesses to see how diverse the values can be. You might even find a solid investment in the process.

No matter if you’re just passing by as part of your schooling, or you’re an advanced investor hoping to bring a business aspect to your strategy, I aim to leave you with a life skill that while you might not profit from immediately– hopefully one day you’ll remember these concepts when you need them most. Or at least be able to remember how to refer back to this information, so that when the opportunity and the ability presents itself, you’ll take advantage.

If you ask any billionaire, be it Mark Cuban or Bill Gates, they’ll tell you that wealth is built over a lifetime. The skills you need to acquire along the way are also accumulated over a lifetime. The ability to discern between businesses through valuation analysis is one of those skills you must have to become really rich. This post is a small part in understanding that. So let’s dive in.

Net Profit Margin

The first profitability ratio to understand is the net profit margin. The word’s meaning is just as it sounds. When you think of high profit margin businesses, think of the expensive and luxurious brands. These kinds of business models are among the most lucrative and exciting to be a part of. Low profit margin businesses don’t make as much money and thus depend on high volume. Think of the Amazons and Walmarts of the world.

Calculating profit is really simple. Take the income and subtract the expenses. The calculation for net profit margin is just as simple. Just take the profit, also called the net income, and divide it by the total revenue. The resulting number will be a decimal place, and should be expressed in a percentage.

So, a company that converts 10% of its revenue into profits will have a 10% net profit margin, and on and on again.

Using profit margin to measure profitability makes the most sense in the plainest definition of the word. Generally speaking, a company with lower profit margins compared to its competitors will be less profitable. A company that grows its earnings over time often uses measures like cutting costs to raise its profit margin and thus raise its profits.

As is the case with many of these profitability ratios, the best way to utilize these ratios is to compare them within their own industry. A company may have favorable ratios just because of the type of business model or industry the company is in. It’s important for the investor to discern between when this is the case and actively utilize multiple ratios in order to minimize this effect.

Gross Margin

Gross margin is a variation of the net profit margin. Gross margin measures the profitability of a company before taxes are considered. This can be useful because tax implications can vary from year to year. Like profit margin, a higher gross margin indicates higher profitability.

Gross margin is calculated by dividing gross income by total revenue. Both figures can be found in the consolidated income statement, and will be expressed in a percentage. This approach gives you a metric to base profitability besides the basic net income numbers that most of Wall Street focuses on.

Return on Equity (ROE)

The next metric is widely used to measure a company’s efficiency. The return on equity, or ROE, measures the profits a company is able to generate based on the value– or equity– of said company. To calculate this ratio, divide the net earnings by shareholder’s equity.

Both the net earnings and shareholder’s equity numbers can be found in a company’s consolidated financial statements. These are more commonly referred to as a company’s annual report or 10-k. To look up any annual report, go to SEC.gov and search for the company based on its ticker. From there, you can look up every financial statement required by law to be filed, including the 10-k.

Once the 10-k is pulled up, you’ll find the net earnings in the income statement of the 10-k. The shareholder’s equity will be found in the balance sheet. The way this number is calculated is by subtracting a company’s total assets by their total liabilities. As with individuals, a company’s net worth can be expressed by this value.

Investing greats like Warren Buffett like to use ROE to find superior returning stocks. This profitability fits well with Buffett’s methodology, which is to find capital efficient company brands that produce excess capital without requiring massive investment. A company like Hershey’s is able to compound its gains every year, simply because the brand is widely recognizable and the cost to produce chocolate remains cheap. This is what leads to a high ROE figure.

Return on Assets (ROA)

Another similar metric to return on equity is return on assets. In this calculation, a company with a high ROA might be highly levered but still able to produce ample capital with minimal investment. As with all investing calculations, the metric should be compared with other measurements to ensure that all aspects of a business model are considered.

For example, though a company might have a high return on assets, I wouldn’t necessarily want to invest if the company also carries a high debt load (which can be measured with a debt to equity ratio). Combining the ROA metric with an equity based ratio like ROE may be useful to weed out unfavorable companies with high levels of liabilities.

The calculation for return on assets is very similar to return on equity. Divide the net earnings by the total assets number found in the balance sheet. Like the previous profitability ratios mentioned, this metric will usually be expressed as a percentage.

A company with a low return on assets number might have a hard time creating growth, simply because it’s hard to build assets. Assets cost money, and a company with a low return relative to its assets will need to keep growing its asset base or find other ways to optimize the return on these assets, thus raising the ratio higher.

Now, you can use a tool such as a stock screener to instantly sort between the common profitability ratios: net profit margin, gross margin, ROA, and ROE.

The tool I want to share with you is a free way to do just that. The website is called FINVIZ.com, and there you can find the common profitability and fundamental financial ratios for any of the over 5,000 stocks traded on the major exchanges. These numbers are being constantly updated with the latest values, and it’s the quickest way I know to sift through a lot of data.

First, go to finviz.com. Then, click on the screener tab. From there, you’ll want to click on the “Fundamental” tab, where you’ll see options for the various ratios. You should see gross margin, net profit margin, return on equity, and return on assets. You’ll even be able to sort operating margin, which is discussed below.

Like I said, you’ll find a variety of options for organizing and screening out stocks you might be interested. Try to compare within industries, while still weeding out stocks that are grossly unprofitable (with low profitability ratios).

If you want some help using the stock screener, I recommend subscribing. You’ll get more ratio explanations and access to the exact stock screen I personally run (in a follow up email).

Operating Margin

The next profitability ratio concentrates on the revenue portion of a business. Because profitability derives itself from the income statement, you’ll see it widely referred to in many of these ratios.

Operating margin falls into that category. It is calculated using only numbers from the income statement. To calculate operating margin, divide the operating income by the net sales. As you can guess, both figures are found in the income statement.

Operating margin helps investors determine how much of the profitability is coming from main operations. You see, net income can come from a variety of places not related to the main core of a business. Gains from selling investment holdings, for example, would be a fine example of income not resulting from operations. In fact, many companies in the S&P 500 have large investment holdings consisting of securities of other S&P 500 companies. This is why you’ll often see the whole market drop sharply at the same time. The losses create a compounding effect, where a stock’s share decrease results in lower earnings in other companies, which creates further stock price decreases which decrease more earnings.

A metric like operating margin lets you ignore the noise that can sometimes cloud earnings. By focusing just on operations, an investor can get a better picture about the core health of a business and quickly determine whether that business is still growing or not.

Free Cash Flow Margin

Another great way to diversify the source of these calculations is by looking at free cash flow margin. The free cash flow margin is derived from both the cash flow and income statement, providing an alternative perspective on the health of the company that can’t be solely derived from the income statement.

I’ve written before about how the cash flow statement can often be a great indicator for the future earnings health of a company, whereas the income statement reveals the current health and the balance sheet describes the long term health. In this way, the free cash flow margin can be a great way to uncover value before it reflects on the income statement.

To calculate free cash flow margin, divide the free cash flow by total revenue. Free cash flow is operating revenue minus capital expenditures. Operating revenue can be found in the income statement, and capital expenditures is in the cash flow statement.

Like the other profitability ratios, free cash flow margin is expressed as a percentage. Because the operating margin and free cash flow margin are based on the revenue, they bypass the possible pitfalls when only looking at earnings. Concentrating on earnings is a typical mistake made on Wall Street. It can be detrimental because earnings are more prone to manipulation than earnings numbers. Additionally, earnings can be temporarily increased from various accounting decisions. For example, the tax burden on the sale of an asset can be reflected in one year or another and still pass an audit. In reality, this decision doesn’t affect the long term financials of a business, but can still cause short term variation which can mislead investors.

For More on Profitability Ratios…

I hope all of these ratios can become useful for you. People with a business background or even a basic interest in business can have a vast advantage when it comes to investing in the stock market.

However, if you clicked on any of the links in this article, you’ll see that there are even more financial ratios to digest. Not to worry, I’ve created a few simple guides to help you learn the important ones, with easy explanations like I gave above.

In fact, there are a few financial ratios that are even more valuable at finding stocks that are poised to outperform the market. In a market where buy low, sell high seems to always prevail, paying a low price– and the right price– for a stock can be the difference between substantial gains. These are the kind of ratios that help you find those stocks.

To learn more about what I am talking about, check out the free guide I made:
How to Read Annual Reports for Beginners

You’ll get a simple breakdown on each financial statement: the income statement, balance sheet, and cash flow statement. You’ll also learn which ratios and metrics to focus on and which to ignore.

Finally, you can also get a basic rundown about stock market investing:
7 Steps to Understanding the Stock Market

This guide, while useful for beginners, is also great for anyone looking to understand fundamental valuation analysis. It turns out that low values in several ratios is correlated to higher stock market gains, and I reveal that and more in the guide.

If I were you, I’d bookmark this page and refer back to it as frequently as I could. I’d read through both of the guides listed. Riches aren’t made overnight, but through persistence.

**All Rights Reserved. Investing for Beginners 2015**
**Profitability Ratios: A Business Approach to Investing**