The three major financial statements statements we looked at in the previous chapters provide you with the data you need in order to understand a company’s profitability, or how much the company’s income exceeds the costs of creating that income. Strong profitability can lead to good earnings growth, which usually leads to growth in a company’s stock price, which, as a shareholder, is what you want.
Remember the net income line at the bottom of the income statement? This is the “bottom line,” showing you what’s left after all other costs and expenses have been subtracted from the revenue. If this number is positive, the company is profitable. That’s not the only number relevant to profitability, but it is a useful data point.
A company that makes a lot of sales may not necessarily be profitable. For example, although Tesla Motors (TSLA) is very well known and has dramatically increased its sales in the last 5 years, the company is not actually profitable. It is spending more on research, innovation, and operations than it is taking in in sales revenue. Investors who buy shares of this company are betting that all this spending will result in future profitability (and therefore increased shareholder value).
Companies increase net income by attracting more sales and/or becoming more efficient (reducing expenses) in running their business. Let’s go over some ratios that can help you parse profitability.
Ratios for Understanding Profitability
The gross margin is a ratio of gross profit to total revenue. Gross profit is shown on the income statement. It is total revenue minus the direct costs of producing a good or service such as materials and labor (the costs of goods sold, or COGS).
Gross margin shows how much of each each dollar of sales is retained after paying out the direct costs of production. An increasing gross margin means that these costs 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.
The operating margin is a ratio of operating income to revenue. Operating income is also a line item on an income statement. This margin tells you how well a company is controlling both its direct (production costs) and indirect (marketing and administrative “overhead” costs). An increasing operating margin means a company is getting more effective and efficient at pricing its products and controlling its expenses.
Net margin is, you guessed it, net income over revenue. Net income, as you might recall from the Income Statement chapter, operating income less interest, taxes, and preferred dividends. The net margin reveals the amount of profit that a business can extract from its total sales.
The higher all of these numbers are, the more profitable a company is. But, as discussed in the next section, context is also important.
Another way that investors like to think about profitability is by comparing profit (return) to the company’s equity, assets, or invested capital. This uses information from both the income statement and balance sheet and gives you ratios like the return on equity (ROE), return on assets (ROA), and return on invested capital (ROIC). In the interest of not overwhelming you, we won’t get into these now, but when you are feeling comfortable with the other profitability metrics covered in this chapter, head over to our profitability metrics glossary to learn about ROE, ROA, and ROIC.
Profitability Context
Just as important as the profitability ratios alone is context about how these figures have changed over time, and how they compare to those of companies in the same industry. Always look to see whether or not the ratios have improved over time, and look at the industry averages or sample similar companies in the same industry to determine whether or not the ratios are high, normal, or low.
While numbers alone can never give you a complete story, improving profitability usually speaks well of the management team, because it suggests they have found a way to operate the business more efficiently over time.
Exercises:
This chapter covered some critical concepts. The exercises below will help bring it all home. For where to find the relevant information in Stock Rover, see this appendix.
- Find the gross margin, operating margin, and net margin for a company in Stock Rover. What sort of trend do you see in the values? Are they increasing or decreasing over the last 5 years? How about over the last 1 year?
- Calculate the current gross margin, operating margin, and net margin using information found on the latest income statement. Check them against the margins you found in #1 – they should be the same (with rounding).
- Compare these margins to those of peer stocks, as well as the industry averages. How does the company compare to peers?
- Read through a recent earnings report from the company. What have they discussed about their sales and expenses that have affected the margins you see on their latest income statement? Do you expect the issues they discuss to improve their margins in the future or to decrease them?
Next: Valuation
This guide was created in partnership with bivio, which provides online investment club accounting and hedge fund management services.
