Calculating Profitability Ratios

Introduction

Corporate earnings are important to you as an investor. If you compare corporate earnings of prospective investments, you will make wiser investment decisions. Profitability ratios provide you with tools you can use to make these comparisons.

In this section you will learn:

• How Do I Use Fundamentals to Make an Investment Decision?
• What Is Ratio Analysis?
• What Can I Learn from Profitability Ratios?
• When Is an Increase in Earnings a Loss?
• How to Use Profitability Ratios to Make Investment Decisions
• Other Ratios to Consider

How Do I Use Fundamentals to Make an Investment Decision?

Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. Performing fundamental analysis will teach you a lot about a company, but virtually nothing about how it will perform in the stock market. Apply this analysis on two competing companies and it becomes clearer which is the better investment choice. In this section, you will learn to use some of the tools of the fundamental analyst.

As an investor, you are interested in a corporation's earnings because earnings provide you with potential dividends and growth. Companies with greater earnings pay higher dividends and have greater growth potential. You can use profitability ratios to compare earnings for prospective investments. Profitability ratios are measures of performance showing how much the firm is earning compared to its sales, assets or equity.

You can quickly see the difference in profitability between two companies by comparing the profitability ratios of each. Let us see how ratio analysis works.

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What Is Ratio Analysis?

While a detailed explanation of ratio analysis is beyond the scope of this section, we will focus on a technique, which is easy to use. It can provide you with a valuable investment analysis tool.

This technique is called cross-sectional analysis. Cross-sectional analysis compares financial ratios of several companies from the same industry. Ratio analysis can provide valuable information about a company's financial health. A financial ratio measures a company's performance in a specific area. For example, you could use a ratio of a company's debt to its equity to measure a company's leverage. By comparing the leverage ratios of two companies, you can determine which company uses greater debt in the conduct of its business. A company whose leverage ratio is higher than a competitor's has more debt per equity. You can use this information to make a judgment as to which company is a better investment risk.

However, you must be careful not to place too much importance on one ratio. You obtain a better indication of the direction in which a company is moving when several ratios are taken as a group.

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What Can I Learn from Profitability Ratios?

The profitability ratios include: operating profit margin, net profit margin, return on assets and return on equity.

Profit margin measures how much a company earns relative to its sales. A company with a higher profit margin than its competitor is more efficient. There are two profit margin ratios: operating profit margin and net profit margin. Operating profit margin measures the earnings before interest and taxes, and is calculated as follows:

Net profit margin measures earnings after taxes and is calculated as follows:

While it seems as if these both measure the same attribute, their results can be dramatically different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to be similar but they tell different stories. As an investor, you are interested in getting a return on your investment. So is a corporation.

Return on assets (ROA) tells how well management is performing on all the firm's resources. However, it does not tell how well they are performing for the stockholders. It is calculated as follows:

Return on equity (ROE) measures how well management is doing for you, the investor, because it tells how much earnings they are getting for each of your invested dollars.  It is calculated as follows:

These ratios are easy to calculate and the information is readily available in a company's annual report. All you need do is review the income statement and balance sheet to come up with the data to plug into the formulas.

But, do not neglect other income statement information that can save you from making a costly mistake.

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When Is an Increase in Earnings a Loss?

Sometimes an increase in company earnings can disguise an operating loss. If a company's operating expenses exceed its operating income, it has an operating loss. If it also has income from investments and tax benefits, this income can offset the loss and show an increase in earnings per share. However, if these other sources of non-operating income are not recurring, the unsuspecting investor may come to an erroneous conclusion about the company's overall financial health. The lesson to be learned here is to carefully scrutinize the financials especially when operating income is negative.

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How to Use Profitability Ratios to Make Investment Decisions

When considering a company as a prospective investment you should review its financial statements. Pay particular attention to the profitability ratios. If you can, calculate the ratios for the same company over several successive years to see if the company earnings are consistent, growing, or declining.

Compare your candidate's ratios to other companies in the same industry. This will help you determine where your candidate stands in the industry.

Do not ignore other financial information on the income statement and balance sheet. Pay particular attention to losses in income items.

For more information on financials, see the sections on Understanding Balance Sheets and Understanding Income Statements.

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Other Ratios to Consider

Price to Earnings Ratio (P/E)

The price to earnings ratio, or P/E, is figured by dividing the stock price by the company's earnings per share (EPS). The P/E is a performance benchmark that can be used as a comparison against other companies or within the stock's own historical performance. For instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, you will want to explore the reasons for the drastic change. If you believe that the ratio is too low, you may want to buy the stock.

You will generally find a P/E ratio based on either the prior reporting year's earnings, or the earnings of the prior four quarters added together. This latter number is referred to as LTM or Latest Twelve Months. While this is useful for understanding the history of a company, most analysts prefer to view a forward-looking P/E ratio. This ratio is calculated by dividing the stock price by the analysts' earnings estimate for the next year or two.

One other note on P/E Ratios. Sometimes, when a company is not doing well, it will buy back shares so that the EPS and P/E Ratio will appear better. This can be seen in the example below.

			Example 1		Example 2
	Net Income		$1,000,000		$1,000,000
	Shares Outstanding		10,000,000		8,000,000
	Earnings Per Share (EPS)		$0.10		$0.125
	Stock Price		$3.00		$3.00
	P/E Ratio		30		24

In the table above, the only change from Example 1 to Example 2 is in the number of shares outstanding. The net income and stock price remain the same. However, by changing the shares outstanding, the EPS has changed quite a bit. This means that the P/E ratio has also changed. At first glance, if a stock's EPS has increased 25% and its P/E ratio has gone from 30 to 24 it might look like a better buy. However, the truth is that nothing has changed but the number of shares. The stock is not a better buy in Example 2 than it was in Example 1.

Where P/E Does Not Apply

When looking at newer companies such as Internet start-ups or bio-techs, there is often no net income, so there are no earnings per share. In these cases the P/E ratio does not apply, forcing analysts to turn to other measures. The most common alternative ratios include: revenues per share, gross income per share or cash flow per share. All these ratios take the relevant number from an income statement, divide them by the number of shares and then divide the stock price by this number.

For example if XYZ Corp. has sales of $1 billion and 100 million shares outstanding, then the revenue per share is $10. If the stock is trading at $90 per share, the price to revenue ratio is 9x.

There are flaws in taking these ratios, but in the absence of a meaningful P/E Ratio, they are a good place to start.

Current Ratio

The current ratio provides an indication of how liquid a company may be in the coming year. To calculate it, take the current assets and divide that number by the current liabilities. You will find all of these figures on the balance sheet.

An answer of 1.0 or better is generally considered good. However this, like other ratios, can depend on a company's current stage of growth. A start-up company should have a lower ratio than an established company. If it does not, then you will want to ask yourself why and do further research.

A current ratio can also be affected by how much long-term debt a company has in relation to its short-term debt. Some companies prefer to use short-term debt and reissue it more often. Other companies minimize their use of short-term debt. Most companies use a mix depending on what is available to them, what is cheaper at the moment and how their economists project interest rates for the future. Hence, this ratio also needs to be used to build a bigger picture rather than in isolation.

Long-Term Debt to Equity

The long term debt to equity ratio can tell you how much debt a company is using to finance its operations. If this number is too high it may signify future liquidity problems. If this number is too low it can signify inefficient use of the financing alternatives available to a company.

This ratio is calculated by taking the long-term debt of a company and dividing it by the shareholders' equity. Be sure to include the company's lease obligations (which can be found in detail in the footnotes of an annual report) when calculating long-term debt.

Start up companies which have access to the debt markets, often have higher ratios than more established companies. In addition, the amount of debt a company can safely issue varies by industry. For example, companies with large manufacturing facilities often have more long-term debt than companies that provide services or software. Therefore, it is useful to look at the ratios of numerous companies in the same industry before drawing any conclusions.

Total Debt to Equity

Since companies can affect either the current ratio or the long-term debt to equity ratio by altering their mix of short-term and long-term debt, this ratio can often be more useful than the other two. This ratio is calculated by dividing all long-term debt, short-term debt and lease obligations by the shareholders' equity.

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How Analysts Present Their Findings