Profitability Ratios: Net Profit Margin, Return on Assets (ROA), Return on Equity (ROE)
The best measure of a company is its profitability, for without it, it cannot grow, and if it doesn't grow, then its stock will trend downward. Increasing profits are the best indication that a company can pay dividends and that the share price will trend upward. Creditors will loan money at a cheaper rate to a profitable company than to an unprofitable one; consequently, profitable companies can use leverage to increase stockholders' equity even more.
The common profitability measures compare profits with sales, assets, or equity: net profit margin, return on assets, and return on equity. Although most financial services publish these ratios for most companies, they can be calculated independently by using net profit and total revenue from the Income Statement of a company's financial report, and total assets and stockholders' equity from the Balance Sheet.
Note that since the Income Statement of a financial report shows the result from a time period, usually 1 year, whereas the Balance Sheet shows the state of a company at a particular time, usually at the end of the company's fiscal year, balance sheet totals, such as total assets and stockholders' equity, are averaged by adding the total at the beginning of the fiscal year to the total at the end, then dividing by 2. More accurate results, especially for highly seasonal businesses, can be obtained by averaging quarters or months.
Net Profit Margin
The net profit margin = the net profit (aka net income) after taxes and excluding extraordinary items divided by total revenues.
| Net Profit after Taxes Total Revenues | ||
| Net Profit Margin | = | |
Example: Calculating Net Profit Margin
A company earned net income of $17,681,000,000 on $60,420,000,000 of total revenue. Since net profit margin is a ratio, we don't have to worry about the last 6 zeros, so we find that:
Net Profit Margin = 17,681 / 60,420 ≈ 29.26%
Many tech companies have high profit margins like this!
Profit Trends Are Better Indicators of a Company's Financial Health
Examining at least 5 to 10 years of profit statements is a better way to determine the financial health of a company, because single-year profits may be misleading. Why? The company may have had an exceptionally good or bad year, or the company may be using different accounting methods than its peers.
Under generally accepted accounting principles, companies are permitted to use various methods to estimate expenses or to calculate expenses, such as depreciation. One company may use accelerated depreciation, while another company may use straight-line depreciation, so even 2 companies with the same revenue and expenses may have different single-year profits. By looking at several years, depreciation expenses will average out, since no company can depreciate more than the cost of an item. Additional accounting methods companies can use may also yield different profits for a given year, but will average out over 5 years or more. Thus, observing the profitability trend is more informative than looking at the PE ratio for a specific quarter or for the year.
Future stock prices will also be determined by whether profitability is increasing, decreasing, or stagnant — something only observable over several years. Trend analysis should also be used when comparing different companies in the same industry, to see how industry profitability itself evolves over time and to compare it with profit trends of other industries.
Return on Assets
The return on assets (ROA) (aka return on total assets, return on average assets, return on investment (ROI), is one of the most widely used profitability ratios because it is related to both profit margin and asset turnover, and shows the rate of return for both creditors and investors of the company. ROA shows how well a company controls its costs and utilizes its resources.
| Return on Assets | = | Net Profit Margin | × | Asset Turnover |
| Net Profit Total Revenue | Total Revenue Average Total Assets | |||
| = | × | |||
| Net Profit Average Total Assets | ||||
| = | ||||
A better name for ROA is return on average assets, since it is more descriptive in how it is calculated.
So a company can have a high return on assets even if it has a low profit margin because it has a high asset turnover. Grocery stores are a good example of a business with low profit margins but high turnover.
Example: Calculating the Return on Assets for a Stock
The following numbers are in millions. Numbers for profit margin and total revenue calculated in the previous example are used here.
Year 1: Total Assets = $63,171
Year 2: Total Assets = $72,793
Average Total Assets = (72,793 + 63,171) / 2 = 67,982
1. Return on Assets = Net Profit / Average Total Assets = 17,681 / 67,982 = 0.2601 = 26.01%
Now we calculate ROA differently using asset turnover:
Asset Turnover = 60,420 / 67,982 = 0.8888 = 88.88%
2. ROA = Net Profit Margin × Asset Turnover = 29.26% × 88.88% ≈ 26.01%
As you can see, equations 1 and 2 yield the same result.
Another method of determining the return on investment is to divide operating income by average operating assets. Operating income is income earned, before taxes and interest, from operating the business, in contrast to earning income from investments. Operating assets are long-term assets, notably property, plant, and equipment.
| Operating Income Average Operating Assets | ||
| Return on Investment | = | |
Return on Equity
The return on equity (ROE), also known as return on investment (ROI), is the best measure of the return, since it is the product of the operating performance, asset turnover, and debt-equity management of the firm. If a firm can borrow money and use it to achieve a higher return than the cost of the debt, then the leveraging creates additional revenue that accrues to stockholders as increased equity.
| Net Profit Average Stockholders' Equity | ||
| Return on Equity | = | |
A better name for ROE is the return on average equity, since like ROA, it is more descriptive of how ROE is actually calculated.
The difference between ROI and ROE is that the return on investment is the return on what the company invests in property, plants, and equipment, and other factors of production, while the return on equity is the return on the amount invested by the investor, the return per dollar of equity.
The return on equity is also equal to the return on assets multiplied by the debt-equity management ratio (aka equity multiplier):
| Average Total Assets Average Total Stockholders' Equity | ||
| Debt-Equity Management Ratio | = | |
ROE = ROA × Debt-Equity Management Ratio
This equation can be broken down further:
| ROE | = | Operating Performance | × | Asset Turnover | × | Debt-Equity Management Ratio |
| Net Profit Total Revenue | Total Revenue Average Total Assets | Average Total Assets Average Stockholders' Equity | ||||
| = | × | × | ||||
| = | Net Profit Average Stockholders' Equity | |||||
The debt-equity management ratio is proportional to the amount of debt being used by the company, because assets = a company's liabilities + stockholders' equity; hence, this ratio shows the amount of leverage the company is using, and the ROE shows how well management is using debt to increase returns for stockholders. However, using debt also entails risk, since interest must be paid even in bad economic times.
Example: Calculating Return on Equity
Year 1: Total Stockholders' Equity = $31,097
Year 2: Total Stockholders' Equity = $36,286
Year 2: Average Total Stockholders' Equity = (36,286 + 31,097) / 2 = $33,691.50
Year 2: Net Profit = $17,681
Return on Equity = 17,681 / 33,691.50 = 0.5248 = 52.48%
Calculating the ROE using average total assets and the debt-equity management ratio yields the same results:
Average Total Assets = $67,982
Debt-Equity Management Ratio = 67,982 / 33,691.50 = 2.0178
Return on Equity = ROA × Debt-Equity Management Ratio = 26.01% × 2.0178 = 0.5248 = 52.48%
(Note that average total assets and ROA were calculated in the prior examples.)