How to use profitability ratios when buying stocks

Author: Steven posted in Stock selection tagged with financial ratios, Investing 101

Profitability ratios are of key importance for serious investors since they measure the ability of a company to generate profit. By comparing profitability ratios of different companies you can evaluate which has better fundamentals and is worth investing in. If a company does not generate profits for its shareholders, it will not last in the long run.

When using profitability ratios to evaluate a company make sure you look at the profitability of the company for at least 5 years back so that you can see the trend and also make sure you measure the profitability of the average company within that industry so that you have a benchmark.

Margin ratios, which include gross margin, operating margin, net margin and free cash flow margin measure the amount of sales dollars that are turned into profits.

Gross margin = Gross Profit / Sales

Gross margin measures in percentage terms the amount of each dollar in sales that a company keeps as gross profit. The higher the gross margin, the more efficient the company is at managing the production of the good(s) it sales.

Operating margin = Operating income / Sales

Operating margin is of more interest to the investor because it is a more complete ratio than the gross margin since it takes into account both the cost of sales and all the operating expenses. It is the profitability margin that best reflects the operating efficiency of a company because it is reflects results of the company’s core business.

Net margin = Net Income / Sales

Net margin measures the amount of each sales dollar that a company keeps once all the expenses (including taxes) are taken into consideration. Since this margin can be distorted by items such as one time payments, you should focus more on the operating margin. That being said, company’s with net margins above 15% are attractive.

Free cash flow margin = Free Cash Flow / Sales

Free cash flow margin measures the free cash flow as a percentage of sales. Recall that free cash flow is the excess cash a company is able to generate that can be used to payout dividends to shareholders, buyback company shares or reinvest in the company business. If you find a company with a free cash flow margin of around 5% that is considered very strong.

The return ratios, which include the return on assets (ROA) and return on equity (ROE), measure the company’s ability of generating returns for the shareholders.

Return on Assets (ROA) = Net Income / Total Assets

Return on assets, also known as return on investment, measures the efficiency of a company at managing its assets to generate profits. Since the ROA of companies operating in different industries can be very different, make sure to compare similar companies.

Return on Equity (ROE) = Net Income / Shareholders’ Equity

Return on equity measures the profit for each dollar of capital invested by the shareholders. The higher the value, the more efficient the company is at using investors’ capital. A company with a ROE of around 15% is what you should be looking for.

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