The goal of each investor is to invest money as efficiently as possible, i.e. to get the maximum return on investment. The profitability of the company can be compared with its economic efficiency, as it shows how much added value the company is able to generate over a period of time (usually a year), which, in turn, reflects the overall rationality of the company to use its resources to make a profit.
When buying shares in any company, the investor is always concerned about how much the company will earn in the future and what its profitability will be.
And very often, the higher the profitability of the company was in the past, the more its shares are valued by the market. To assess the profitability of the company there is a group of profitability multipliers.
The main one among them – ROE (Return On Equity) – shows the profitability of equity capital and is the ratio of net profit to equity capital of the company. Return on Equity = Net Profit รท Shareholders Equity*100 The multiplier shows how the company is able to generate profit from equity.
Let’s analyze the concept of equity capital. The point is that the organization is formed at the expense of the founders’ funds, who have the corresponding shares. But later on the company starts to attract loans for its development and acquire various assets at their expense. But for additionally attracted money one has to pay, which further reduces the net profit. Therefore, it is reasonable to understand how much the company’s capital, which is not burdened with liabilities, is able to generate profit.
For example, let’s calculate ROE for Apple. We take the data from the financial statements. We will divide the net profit for the past 4 quarters of 53.318 billion dollars to equity 126.878 billion and multiply by 100. We get ROE equal to 42%. That is, each dollar of equity generates 42 cents of profit.
The enterprise is considered satisfactory from the point of view of the analyzed indicator when its value is higher than average yield on government bonds, otherwise it is more profitable for shareholders to transfer to risk-free assets. ROE multiplier is extremely important at the analysis of profitability of the enterprise as it characterizes risks of the company and ability to generate profit with own capital.
ROE does not show how loaned assets generate profit, so it is useful to analyze ROE together with ROA (Return on Assets).
ROA (return on assets) is the ratio of net profit to company assets. Return on Assets = Net Income/Total Assets. It shows a company’s ability to effectively use its existing assets to create profit. Also this indicator reflects the average return on all sources of capital – equity and debt. Company assets – the aggregate of property and cash assets owned by the company (buildings, structures, machinery and equipment, inventories, bank deposits, securities, patents, copyrights, property with a monetary value).
Let’s calculate ROA using the example of Apple. We divide net profit 53.318 billion by assets equal to 367.502 billion and multiply by 100. We also take the data from the company’s reports on the official website. This results in a 14.5% ratio.
Comparison of companies in terms of return on assets can be correctly carried out only within one industry. For example, in industries with high asset turnover as retail trade, this indicator will be significantly higher than in industries where asset turnover is traditionally low, as in machine-building.
The profitability of the company as a whole shows the Return On Sales (ROS) ratio. This is the ratio of net profit to total revenue of the company ROS = (Net Income / Revenue) x 100%. It reflects the share of profit attributable to each dollar earned by the company. It is also called Profit Margin.
Let’s calculate the profitability of Apple’s business. Let’s divide the profit for the last 4 quarters, i.e. the year, it’s 53.318 billion, to the revenue for the same period, it’s 247.417 billion. They sell a lot)))) and multiply it by 100, we get the sales profitability of 21.5%.
Due to the volatility of net revenues, it is advisable to calculate the profitability of business for several periods, comparing it with similar indicators of other companies in the industry. Profitability shows the general expediency of investments for investors.
If it is lower than the yield of risk-free instruments, investors may prefer them. Profitability does not reflect the market value of shares. If a company shows good profitability, its shares are often highly overvalued by the market. Therefore it is better to buy securities of such companies on corrections.
Well, now you can calculate your own profitability for analysis and selection of shares. If you have no desire and no time to look through reports of companies, you can use such sites as finviz.com or finance.yahoo.com, where the main multipliers have already been calculated.