Stock selection: profitability of the company
A competent investor when choosing companies, stocks which he wants to buy, will definitely analyze the company's performance indicators. One such key indicator is profitability.
What is profitability, what types of profitability are there and how is it calculated?
What is the profitability of a company?
Profitability is an economic indicator reflecting the efficiency of the company's resource utilization.
Resources mean not only raw materials, but also cash, personnel and other assets. Profitability can be calculated for the company as a whole or for any individual asset.
Profitability is a relative measure and shows change, usually in percentages.
If the profitability value is positive, it means that the company is making a profit, if it is negative or equal to zero, the company is making a loss.
Calculating profitability is necessary when forecasting profits, comparing a company to competitors, and estimating potential return on investment.
In addition, the profitability of a company is mandatorily calculated when the company is sold. The less the company spends resources and the more profitable it is, the higher its price.
Profitability threshold or break-even point
The profitability threshold is the amount of minimum profit required to cover costs. If this term is applied to investment, it refers to the investment, if it is applied to production, it refers to the cost of production.
Sometimes the profitability threshold is also called the break-even point.
How the profitability of a company is calculated
To calculate the profitability of a company, you will need financial information found in several accounting forms:
Profitability is calculated according to the formula:
Profitability = profit / relevant profitability ratio
The coefficient refers to the indicator whose profitability is to be determined multiplied by 100%. It shows the efficiency of utilization of a specific type of resources.
To evaluate the profitability of the company as a whole, several profitability ratios are used.
Return on Assets ROA (Return Of Assets) ratio
Return on assets ROA ratio shows the efficiency of using the company's available assets to generate profit. It is calculated according to the formula:
Coefficient ROA = (profit after tax / average value of assets for the same period) x 100%
The higher the return on assets ratio, the higher the efficiency of their utilization by the company.
ROE (Return On Equity) and ROCE (Return On Capital Employed) ratios
The return on equity ratio is divided into two measures.
ROE ratio shows how efficient the company's own funds invested in the business are. Its formula is as follows:
Coefficient ROE = (net income / equity of the company) x 100%
If you add the borrowed funds to the company's own capital, you get the return on capital employed ratio, which indicates the efficiency of the company's use of not only its own capital, but also investments.
ROCE ratio = (net income / (company's capital + attracted investments)) x100%
Return on Investment ROI (Return On Investment) ratio
ROI is probably the key indicator for an investor. It is analogous to the return on equity ratio, but using any other types of investments (bank deposits, stock exchange instruments, etc.) for calculation. It shows how effective the investment in the company is and is calculated using the formula:
Coefficient ROI = (profit / amount of investment) x 100%
The higher the ROI, the more profit the money invested in the company generates.
Return On Sales ROS (Return On Sales) ratio
Return on sales ratio ROS is the most commonly requested profitability indicator. It clearly demonstrates how many percent of profit there is per one monetary unit of sales profit.
The return on sales ratio is calculated according to the formula:
Coefficient ROS = (profit after tax / sales revenue) x 100%
In determining its pricing policy, the company uses exactly the return on sales ratio. In addition, this coefficient, when substituted for the profit after tax indicator, is used for evaluation:
- operational efficiency - it is necessary to replace profit after tax with income from operations;
- performance - you need to replace profit after tax with gross profit data.
Nuances of using profitability ratios
In fact, there are many more profitability ratios that allow you to evaluate this or that indicator of a company. When using them, every investor should be aware of a few basic nuances:
- The value of any coefficient taken by itself does not provide any objective information. In order to assess the effectiveness of an indicator, it is necessary to track the change in the corresponding coefficient over a long time interval.
- Profitability ratios will not always provide an accurate assessment of a company's performance. For example, if long-term investments are used, the ratios will be low. For an adequate assessment, it is necessary to constantly recalculate and analyze them over different time periods.
- The price of assets may change over time, but the calculations are based on their value determined only once. Accordingly, it is necessary to take into account changes in the price of assets depending on market conditions.
Nevertheless, the profitability of a company remains the most important indicator of a company's performance and is one of the key indicators for its valuation in the stock market.