The Curious Investor

Now that we’ve gone through the basics of lookings at financial statements and valuation, we can go back to ratio analysis which I attempted to write about in the first Fundamental Analysis series and failed badly at. We’ll take it a bit slower this time and try to be a bit more methodical. We’ve actually already done a little ratio analysis in this series. Inventory turn and receivables turn are two very good examples of a simple ratio that can be made using data from financial statements to give further insight on a company and its operations. Other financial ratios we’ve looked at include EV to EBITDA and P/E. What needs to remembered when you look at financial ratios is that they are not necessarily instructive in and of themselves. They can give you a general idea, but they are most powerful when used as a means for comparison - either between like companies or between the company in question’s own historical ratios.

Today, we’ll be going through Profitability Ratios. Measuring profitability is probably the main impetus for any sort of fundamental analysis. The most common profitability measures are profit margin, operating margin, return on equity, return on assets, and return on invested capital. Typically, these ratios are scaled to be reported as percentages.

Profit margin is simply net income divided by revenues. It shows the proportion of every dollar of sales that can actually be kept as earnings. A high profit margin compared to peers in the industry implies that the company has some sort of competitive advantage over its peers - better control of costs, brand recognition, proprietary knowledge, etc. While a good sign, it is up to the person analyzing the stock to be able to ascertain that a company actually does have a sustainable competitive advantage. Another good trend is an increasing profit margin which implies that the company is improving its competitive position in the market. Profit margins can also be used to determine whether or not growing earnings are healthy for the company. Earnings growth with a decrease in profit margin is a sign that the company’s earnings growth may not be sustainable.

Operating Margins are similar to profit margins in that they are defined in almost the same way except, rather than net income, operating income is divided by revenues (also known as net sales). Operating income is the money a company makes strictly from ongoing operations before interest and taxes. It is sometimes described synonymously with EBIT (Earnings Before Interest and Taxes) though this is not entirely correct as EBIT will usually include non-operating income. When calculating operating margins, you want to make sure as best you can that you only have income from operations in the calculation. This will give a more accurate picture of a company’s operating performance and whether or not it is successfuly generating earnings from what should be its core business.

Return on Equity is calculated as net income divided by shareholders’ equity. It is a measure of how much return a company is generating on the money invested by the owners of the company. A high ROE is a sign that money reinvested in owning the company is well spent. ROE provides an interesting catch-22 in that, above a certain threshold (say about 10% but it can vary), it is a sign that a company can sustainably pay dividends while still having funds to reinvest. ROE, however, is really only valuable if the company reinvests its earnings and obtains the high return that ROE suggests and, as such, high ROE is a good argument for a company focused on growth not to be paying high dividends to its shareholders.

Return on Assets is simply net income divided by total assets. It’s the other part of the balance sheet from equity. It measures how well a company is utilizing its assets. I’m don’t rely on this ratio all that much and I assume it gives some sort of indication on whether or not a company should be interested in divesting assets or use capital to build its assets. One way or another, it’s impact on determining whether or not to invest in a company is indirect at best.

Return on Invested Capital which is my personal favorite, as well as probably the best kept secret of profitability ratios, serves as a sort of “adjusted” Return on Equity and can sometimes be more valuable as it attempts to only use income generated by operations and strips out extraneous capital from the shareholder’s equity to result at a number which is more highly representative of the return a company is generating on the money shareholders have put it. It’s not easily pulled straight off of financial statements and requires some calculations. For those interested, I’d suggest searching on the internet, reading a Joel Greenblatt book (The Little Book That Beats the Market), or leaving a comment here and asking me to write up a tutorial on it which I may do sometime in the future.

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