# 5 Important Profitability Ratios To Identify Stocks Of Good Companies
Remember the popular phrase, “Show Me The Money” from the movie Jerry Maguire. In a clip from this movie, a football player presses his agent Jerry Maguire (played by Tom Cruise) to negotiate a better contract for him by repeatedly saying, “Show Me The Money”.
Isn’t this the exact phrase that investors ask the management of companies. Can you show me the Money? Can your business bring me good returns for the capital I provide? Can your business use my money wisely?
A smart investor will always try to assess a company before investing on the following parameters:
1. How well a company uses the capital (either raised through shareholders or through money borrowed as debt from lenders)?
2. How well a company uses its assets (like land, machinery etc) to generate sales?
3. How well a company manages its expenses? What part of the sales/revenue a company is able to keep after deducting expenses (Revenue – Expense)?
In order to answer these questions we don’t have to really break our head. Thanks to the Profitability ratios which are simple and easy to use. Profitability ratios indicate how efficient a company is in generating profit for its shareholders using its capital or assets.
These ratios help us in segregating good companies from bad ones.
If I were to give you a choice to invest in Bata India or Liberty Shoes. How will you decide which one to choose? Well. Go on. Read the article to figure out.
So without wasting any more time, let’s discuss 5 profitability ratios that every investor should know about. I will try to keep it as simple as possible and off course there will be real life examples to demonstrate the use of these ratios.
Table Of Contents
1. Return On Equity (ROE)
ROE is a widely used financial ratio used by investors to judge the percentage of profit a firm earns on the capital provided by its shareholders.
For example, if a company makes a profit of 20 crore by using shareholder’s investments of 100 crores then its ROE will be expressed as a percentage of (20/100) which is 20%.
This means that for every 100 Rs provided by shareholders, the firm generates a profit of 20 Rs.
Formula for calculating ROE is as follows:
ROE = (Net Profit / Shareholder’s Equity) X 100
Here Net Profit represents the portion of sales/revenue retained by the firm after paying all expenses, interest and taxes. While shareholder’s equity is the total shareholder’s capital available with the company
How To Use ROE
1. A higher ROE is an indicator of an efficient firm which is able to generate higher return on capital for its shareholders. A rising ROE is preferred by investors as it may indicate a firms ability to generate more profit for its shareholders for every unit of shareholder’s capital.
2. I usually prefer companies with ROE >= 20% and this level of ROE should be maintained for a period of 5 years or more. This ensures a firm’s ability to consistently generate higher returns for its shareholders.
3. Avoid companies with ROE < 12-13% as such companies are not very efficient in generating profits for its shareholders. One should also avoid companies with negative ROE
ROE can be used to measure various companies within the same industry. For example, let us consider an investor wants to compare the following cement manufacturing companies in India based on ROE (data source: moneycontrol.com)
4. One thing we can clearly see is that all cement companies above have very low ROE. Low ROE for cement companies is due to the fact that cement companies operate in a highly competitive environment.
They are also affected by weak household demand and subdued cement prices. Therefore they are not able to generate a higher profit for their shareholders.
5. Secondly, we see that JK Lakshmi Cement’s ROE is the lowest of the 3, averaging around 4.2 for five years
6. Purely based on ROE, Deccan Cement and Shree Cement fare far better as compared to JK Lakshmi Cement.
ROE And It's Drawback
ROE has a major drawback. It ignores the money borrowed by a firm (Debt) in its calculations. It focuses exclusively on capital provided by shareholders and ignores money borrowed from lenders like banks.
Thus if a company uses a lot of debt it may be able to report a very high ROE, as debt will also contribute in generating income.
So ROE is a good indicator of efficiency provided the firm has less debt as compared to equity (shareholder’s capital). You can read more about debt to equity ratio here.
Let us see an example where a company has high ROE but very high debt. Consider the ROE and Debt To Equity ratio of Uttam Sugar Mills given below (src: https://money.rediff.com/companies/Uttam-Sugar-Mills-Ltd/11320023/profit-and-loss)
From above data we can see that Uttam Sugar Mills has very high debt as compared to the capital available from shareholders (shareholder’s equity). In Mar 19 it has a debt of 604.49 cr while shareholder’s equity was 234 cr. In such cases ROE is not much helpful as company is generating profits majorly from borrowed capital which is not included in ROE.
2. Return On Capital Employed (ROCE)
ROCE is my favourite profitability ratio to segregate sound companies from poor performing companies.
ROCE measures how efficient a business is in generating profit using total capital available to it (debt + shareholder’s equity). I find ROCE to be a better measure than ROE to figure out companies which are better at using money and generating higher returns.
ROE considers only the profits generated by a firm from only one source of capital which is shareholders equity (money belonging to shareholders). It ignores the fact that companies borrow money as well from lenders (Debt). It is here that ROCE comes in handy.
Formula for calculating ROCE is as follows:
ROCE = Profit Before Interest & Taxes / Total Capital Employed
Here, Total capital employed is a sum of shareholder’s equity (money belonging to shareholders) and overall debt (money borrowed from lenders which needs to be repaid with interest).
Total capital employed = Shareholder’s Equity + Total Debt
How To Use ROCE
1. As an investor we should look for companies with an increasing or stable ROCE over a period of 5 years or more.
2. I usually prefer companies with ROCE >= 20% and this level of ROCE should be maintained for a period of 5 years or more. It is even better if the ROCE for a firm is increasing over a period of time.
3. ROCE can be used to compare various companies in same sector to identify a company making the most efficient use of capital among them. Let us consider an example of 3 footwear manufacturers in India.
4. Based on ROCE comparison we can clearly see that Liberty Shoes has a very low average ROE of 10% as compared to Relaxo and Bata India. Just by looking at the ROCE an investor comes to know that Relaxo and Bata are much superior to Liberty Shoes in making use of shareholder’s equity and debt available to them
5. Average ROCE of Relaxo is 27% over a period of 12 years while for Bata the average ROCE is 31%. This is much higher than our benchmark of 20%
Time For A Question ?
Looking at the ROCE numbers for 3 cement companies below, can you figure out which one is generating the lowest return on capital?
Make a note of your answer for now as we will repeat this exercise for other profitability ratios as well.
3. Return On Assets
Companies use assets to generate revenue. Assets are a resource owned by companies that generate future monetary/economic benefits for a company. A few examples of assets are land, machinery, cash, patents, investments etc.
Now in order to determine how good a company is at utilizing its assets an investor can look at another profitability ratio known as Return On Assets (ROA).
The formula for calculating ROA is as follows:
Return On Assets (ROA) = (Net Income / Average Total Assets) X 100
If a company has Net Income of say 300 crore and average total assets equal 2000 crore. Its ROA will be 15% which essentially means that for every 100 Rs invested in assets the company generates a net profit of 15 Rs.
Therefore, ROA helps an investor to determine the net profit a company can generate using its total assets.
How To Use Return On Assets (ROA)
1. Higher the ROA for a company the better it is. As an investor always look for companies with a relatively stable or increasing ROA over a period of 5 years or more. By relatively stable I mean that a percent or two here or there is fine.
2. We can use ROA to gauge the effectiveness of different companies in the same sector to convert profits using their assets. Let us consider the example of two footwear manufacturers in India
3. From above data we can infer that Liberty shoes has a very low ROA averaging around 2.3% as compared to Relaxo Footwear which generates a ROA of 11.858%. A simple comparison over a period of 5 years shows us that Relaxo is using its assets much more efficiently than Liberty shoes
Time For A Question ?
Looking at the ROA numbers for 3 cement companies below, can you figure out which one is a poor user of its assets?
Just as we did for ROCE, now make a note of the company which seems to be making poor use of its assets (ROA)
4. Net Profit Margin (NPM)
Companies sell products/services to generate sales/ revenue. Once the sale is made there are various expenses like raw material purchase, salaries, utility bills to pay.
Then there is depreciation, interest payments on debt borrowed, and taxes to the government to be paid. After deducting all these outflows what remains behind is the net profit.
Just like you may have an annual salary of say 15 lakh rupees and after deducting all expenses like housing, commutation, food, tax etc you get to keep 3 lakh rupees at the end of each year.
This final amount left over after deducting all expenses can then be used by the company for distributing a part of it to shareholders, retain a portion of it as reserves or use it for future expansion of business.
Formula for Net Profit Margin is as follows:
Net Profit Margin = (Profit After Tax / Total Revenue) X 100
Net Profit and Total Revenue can be found on profit loss statement of a company
A company that retains 12 Rs as profit after deducting all expenses (inlcuding interest payments and taxes) on total revenue of 100 Rs will have a Net Profit Margin of 12%.
A higher NPM indicates a company is able to retain a higher percentage of sales as profit for its shareholders.
Calculating Net Profit Margin Using Profit Loss Statement
Here is a quick self explanatory example of calculating Net Profit Margin from Profit Loss statement of Relaxo Footwear.
How To Use Net Profit Margin (NPM)
1. Always look for companies with a stable NPM or rising NPM over a period of 5 years or more. Companies with increasing NPM over a period of time is an indication of a sound financial company that has been through the ups and downs of the economic cycle.
2. NPM is a very effective profitability ratio to compare companies within the same industry. For example consider the NPM of 3 footwear manufacturers in India given below:
3. Based on above comparison we can clearly see that Liberty Shoes has a very poor NPM averaging around 1.8% whereas Bata and Relaxo have a much higher NPM of 8.7% and 7.45% respectively. This means that Bata and Relaxo are much better at retaining a portion of their total revenues as profits.
4. We can also infer that Liberty shoes seems to be struggling with making profits as its NPM has been in a declining trend.
On the other hand Bata India has been able to increase its NPM from 8% to 11.2% in 2019. Relaxo’s NPM is more or less stable around 7% – 8%.
Based on this simple analysis you can see, how we can filter out poor performing companies by using NPM.
Fluctuating Net Profit Margin
1. Companies which have widely fluctuating NPM is an indicator of a commodity business or a cyclical business. Some examples that come to my mind are sugar, steel etc.
Investors should be very careful while investing in such companies there margins can decline suddenly which can lead to a sharp correction in stock prices.
2. For example consider the below example of a sugar manufacturer, Balrampur Chini Mills. Just look at how volatile is the NPM over the years fluctuating from a -1.93% to 13.27%.
The main reason for such fluctuating NPMs is that sugar prices are market driven depending mainly on the sugar production during the sugar season and existing sugar inventory within the country.
If there is over production of sugar it leads to a fall in price of sugar and impact the profitability of the company and vice versa. This leads to a fall and rise in NPM accordingly.
Time For A Question ?
Looking at the Net profit margin numbers for 3 cement companies below, can you figure out which one is not able to retain much profit?
Just as we did for ROCE and ROA, now make a note of the company which has lowest NPM
By now we have compared ROE, ROCE, ROA and NPM of 3 cement manufacturers. I am sure you would have come to know the cement manufacturer which is the most inefficient user of capital.
Please feel free to write your answer in the comments section below.
5. Operating Profit Margin (OPM)
As we discussed in the previous section, Net Profit measures the portion of revenue a company retains after paying all its expenses, accounting for depreciation on assets, interest payments and taxes paid.
Similarly the portion of profit a company retains after subtracting the operational expenses but before paying interest and taxes is called Operating Profit.
In order to avoid any confusion let us first understand how to calculate Operating Profit from Net Profit.
Operating Profit = Net Profit + Interest + Taxes – Other Income
Let us now see the profit loss statement of Relaxo Footwear to understand the difference between Net Profit and EBIT. We will focus on the financial numbers for Mar 2019 for our reference (represented by column K)
From above statement we can see that Relaxo’s net profit (represented by row 12) is calculated by subtracting expenses, depreciation, interest and taxes from its sales numbers. So far Mar 2019 net profit is equal to 175.44 crore.
Now in order to calculate Operating Profit use the formula Operating Profit = Net Profit + Interest + Taxes – Other Income
For Mar 2019, Relaxo has made an interest payment of 6.9 crore and tax payment of 267.98 crore and other income of 12.98 crore. Applying the above formula we get operating profit of (175.44 + 6.9 + 92.54 – 12.98) 261.9 crore.
Thus while calculating operating profit we ignore the effect of interest and taxes on a company’s earnings and focus on on expenses like cost of raw materials, salary, rent, utility bills, advertisement expenses, depreciation of assets. These expenses are called operational expenses.
Now in order to calculate Operating Profit Margin we use the below formula:
Operating Profit Margin = (Operating Profit / Revenue) X 100
Thus for the above example Relaxo’s operating profit margin will be 261.9 crore / 2292 crore which equals 11.4%.
How To Use Operating Profit Margin
1. Always look for companies with a stable OPM or rising OPM over a period of 5 years or more. Companies with increasing OPM over a period of time is an indication of a sound financial company that has been through the ups and downs of the economic cycle.
If we look at the OPM for Relaxo footwear has increased from 7.6% in 2011 to 12.8% in 2018 which is a good sign.
2. Higher the OPM for a company the better it is at controlling its operational expenses
3. Just like Net Profit Margin, OPM is also a very effective profitability ratio to compare companies within the same industry.
4. Similar to NPM, if operating profit margin of a company fluctuates a lot over a period of time then it is an indicator of a commodity business or a cyclical business like sugar or steel.
Let Us Summarize
Before we end let us quickly summarize all 5 profitabiltiy ratios
1. ROE is a return ratio which give an insight into the returns a firm can generate using shareholder equity. Prefer companies with ROE > 18%
2. ROCE is a return ratio that provides an insight in to the operating profit can generate using its shareholder’s capital and debt. Prefer companies with ROCE > 18%
3. Return on assets (ROA) is a return ratio that measures how much profit a firm can generate by sweating its assets
4. Net Profit Margin (NPM) is a margin ratio that tells us what portion of revenue a firm is able to retain after deducting operational expenses, interest and taxes
5. Operating Profit Margin (OPM) is a margin ratio that tells us what potion of revenue a firm is able to retain after deducting operational expenses but excluding interest and tax payments
6. A higher number for all 5 ratios described above is an indicator of a sound company
Combine Profitability Ratios With Leverage Ratios
You can combine the above 5 ratios with the two leverage ratios I discussed in my previous blog post. Click here to check them out. These ratios combined are a powerful tool to help weed out poor performing companies. They make sure that you select only the best stocks for your investment.
That’s it. This brings us to the end. I hope you will benefit from these profitability ratios. Please share this article with similar minded people and don’t forget to subscribe folks. Happy Investing.
Disclaimer: Stocks mentioned in the post are only for tutorial purpose. Author does not recommend any stock. Please do your due diligence before investing.
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