One major feature of quality that fundamental investors look for in companies is profitability. That means the ability to translate revenue (top line) into profits (bottom line). Increasing profitability metrics over time suggests that a company is becoming more efficient. In this article, we’ll detail the most common indicators of profitability.
So buckle your seatbelts, for a wild and crazy ride into the world of profitability metrics!
Okay, it isn’t really that exciting, but it is very practical. So, uh, cozy up with a nice mug of tea and read on.
The gross, operating, and net margins can all be derived with data found on the income statement. Note that on the income statement, revenue actually means net sales, which accounts for returns, allowances, and discounts.
Gross margin, or gross profit, shows how much of each each dollar of sales is retained after paying out the direct costs of production, such as material and labor. The gross profit margin serves as the source for paying additional expenses and future savings. It is calculated simply by subtracting cost of goods sold (COGS ) from total revenue and dividing that number by total revenue, like so:
Gross Margin = (Revenue – Cost of Goods Sold) / Revenue
An increasing gross margin means that the costs of goods sold are decreasing relative to sales, which is a good thing. Decreasing costs can be due to factors like new operational efficiencies or a drop in the cost of materials. Different industries may have vastly different average gross margins, so be sure to compare gross margins for companies in the same industry.
Operating margin is a margin ratio used to measure a company’s pricing strategy and operating efficiency. It measures what proportion of a company’s revenue is left over after paying for variable costs of production. Whereas gross margin looks only at direct production costs, operating margin also includes indirect costs (overhead) such as marketing and administration. The calculation is this:
Operating Margin = (Revenue – Cost of Goods Sold – Operating Expenses – Depreciation & Amortization) / Revenue
An increasing operating margin means a company is getting more effective and efficient at pricing its products and controlling its expenses.
Net margin is the percentage of revenue left after all expenses have been deducted from sales. Here is the calculation:
Net Margin = (Revenue – Cost of Goods Sold – Operating Expenses – Depreciation & Amortization – Net Interest Expense – Taxes) / Revenue
This measurement reveals the amount of profit that a business can extract from its total sales.
As you can see, these three metrics are both simple to understand and powerful for making sense of the effectiveness of a business’s operations. If you see gross, operating, and net margins changing at different rates, you can begin to identify where efficiencies are occurring (or not occurring). For example, if gross margin is flat, but operating margin is increasing, you know that there are savings in the indirect costs of production. If net margin is flat while gross and operating margins increase, you can glean that expenses such as depreciation and interest expense have gone up.
In general, when you see these three ratios increasing, it tells you that the business is becoming more operationally efficient.
Now onto a different kind of efficiency, capital efficiency.
ROE, ROA, and ROIC
These three metrics measure how much return (net income, AKA profit) is derived from a business’s capital. They each have their advantages and limitations.
Return on Equity (ROE)
One of the most commonly used profitability metrics, return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. Shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own.” Shareholder equity represents the assets created by the retained earnings of the business and the paid-in capital of the owners.
ROE = Net Income / Equity
Although this metric is very common and dead simple to compute, ROE is probably the most limited measure of the big three because of the way it ignores capital structure. Companies that have a lot of debt can score better than a company with less debt even if both are using their capital (one from equity, one from debt) to effectively grow their business. Let’s explore this and some of the other limitations of ROE…
A write-down is a technique that many companies use on a regular basis when valuing assets. In a write-down, the company reduces the value of an asset because they believe that it is currently overvalued according to market prices. For this they take a charge against net income in the current quarter (and year). But in subsequent periods, the equity remains marked down and therefore ROE increases. Therefore, write-downs can cause a large jump in ROE even though the company has actually devalued its assets.
Stock buybacks can also have a drastic effect on return on equity. Companies will regularly engage in stock buybacks for a number of different reasons. Sometimes, they will actually buy stock back from the market for the purpose of improving financial ratios such as return on equity. When a company buys a large number of shares from the market, they reduce the shareholders’ equity significantly. This mean they also improve the return on equity ratio. Nothing fundamental changes with the way that the company was doing business, but the return on equity jumped significantly.
As mentioned above, another limitation with return on equity is that it does not take into consideration the amount of debt a company owes. Therefore, a company could have excessive debt and still look like it is handling things well according to ROE.
In short, ROE is a broad metric that should be taken with a grain of salt, or at least not used without context.
Return on Assets (ROA)
ROA compares a company’s profit to its total assets, which gives an idea as to how efficient management is at using its assets to generate earnings. This figure is also sometimes this is referred to as “return on investment.” Like ROE, the ROA calculation is dead simple:
ROA = Net Income / Total Assets
Total assets are equal to equity plus debt. So, unlike ROE, this metric does incorporate debt structure, and companies that carry a lot of debt will have a lower ROA.
Return on Invested Capital (ROIC)
Return on invested capital (ROIC) measures the cash rate of return on capital that a company has invested. ROIC gives the clearest picture of exactly how efficiently a company is using its capital, and whether or not its competitive positioning allows it to generate solid returns from that capital.
The calculation has a bit more going on than the previous two, and for that reason you won’t find it everywhere, take a look:
ROIC = Net Operating Profit After Taxes / Invested Capital
Net Operating Profit After Taxes is known as NOPAT.
NOPAT = Gross Income – Operating Expenses – (Depreciation & Amortization) – Taxes
Invested Capital = (Fixed & Intangible & Current Assets) – Current Liabilities – Cash
Notice the numerator is a nonstandard measure, meaning you will not find it on any standard financial statement. You can think of net operating profit, after taxes (NOPAT) as net income with interest expense (net of taxes) added back. This shows what the profit would be without taking a company’s capital structure into consideration.
Because ROIC attempts to show how much a company earns based on the capital actually deployed by the business, cash or debt on the balance sheet is not considered relevant (nor is the income or costs that accrue from holding cash or having debt). In other words, ROIC looks only at business efficiency with deployed capital.
As with other profitability metrics, it is not only the level of ROIC that matters, but also the trend. A declining ROIC may be an advanced indicator signaling that a company is having a hard time dealing with competition. On the other hand, an increasing ROIC may indicate that a company is distancing its competitors or that it is being more efficient at deploying capital. For ballpark guidance, if a company has an ROIC in excess of 15% for a number of years, it most likely has a competitive moat. That said, whether a company is creating value depends on whether its ROIC exceeds its cost of capital (equity issuance or debt).
We hope this article has shed some light on the differences between these metrics and how they can be used to tell you about a company’s profitability and efficiency. Remember they are most effective when used in context, so be sure to look at historical values and compare with peers.
You can find these metrics in multiple places throughout Stock Rover, including in the Table (add them to any view ), Chart (add through the Fundamentals menu), and Insight panel (see the Profitability section of the Summary tab, or add these metrics to the Peers tab).