Profit and Return on Investment

Profits drive stock price

A company's share price is ultimately driven by its profitability. Your task as an investor is to identify those companies with strong prospects at the earliest possible stage.

Profitability ratios are used to decide whether a company is earning acceptable profits and to determine whether the profits trend is rising or falling. They are also used to compare the relative performance of companies in a given sector.

Gross profit margin

Gross profit margin is gross profit (sales minus cost of goods sold) expressed as a percentage of company sales.

Example of Gross profit margin

Gross profit margin = (Gross profit ÷ Sales) x 100%

If gross profit is BP 100m from sales of BP 400m, the gross profit margin is 25%.

The gross profit margin is usually fairly stable for each company. A decline in the margin may be caused by several factors, including a rise in the cost of goods purchased from suppliers, a fall in the selling price due to competition or lower customer demand.)

Net profit margin

Net profit margin is the profit (net income) earned by a company as a percentage of sales. Net income is the profit figure after all the company expenses have been deducted.

Example of Net Profit Margin

Net profit margin = (Net Income ÷ Sales) x 100%

If net income is BP 1m on sales of BP 10m, then the profit margin is 10%.

A healthy net profit margin is a sign of corporate profitability, although, as with the gross profit margin, you should compare this figure with the profit margins of other companies in the same industry sector.

Return on equity (ROE)

Gross and net profit margins are useful performance indicators. Ultimately, however, you should be more concerned with the return on your investment than the company's returns (profits), because you will want to know how well the company is using the money you have invested.

Return on equity (ROE) shows the performance of the company in relation to the capital invested in that company. ROE is the amount, expressed as a percentage, earned on a company's common stock for a given accounting period. It is calculated by dividing a company's earnings by the average stockholders' equity throughout the accounting period.

Example of Return on equity

Here is the formula for calculating return on equity:

ROE = (Post-tax earnings ÷ Stockholders' equity) x 100%

Company X's annual report reveals the following:

Earnings: BP 3,000,000
Average stockholders' equity: BP 10,000,000

Calculate the return on equity as follows:

ROE = (£3,000,000 ÷ £10,000,000) x 100%
  = 0.3 x 100%
  = 30%

By relating earnings generated to shareholder equity, you can easily see how much value in earnings is created from company assets. For example, if the ROE is 30%, then 30 pence of earnings are created for each pound that was originally invested.

Return on capital employed (ROCE)

An investment measure related to ROE is return on capital employed.

Return on capital employed indicates how well a company can generate cash from its total capital base (stockholder's equity plus long-term debt).

Example of Return on capital employed

ROCE is calculated as company earnings divided by average capital employed. The formula is as follows:

ROCE = (Earnings Before Interest & Tax (EBIT) ÷ Average Capital Employed) x 100%

Comparing ROE and ROCE

Let's look at an example featuring two companies with identical earnings before interest and tax (EBIT).

  Company A Company B
  Million Million
Debt 50 250
Equity 250 50
Total Capital 300 300
     
EBIT 30 30
Interest on debt @ 5% 2.5 12.5
Tax 12.5 7.5
Post-tax earnings 15.0 10.0
Return on Equity 6% 20%
Return on Capital Employed 10% 10%

Note how ROCE is identical but ROE is far higher for Company B even in spite of much higher interest repayments. The reason for this is that Company B carries proportionately less equity in its capital base (50m against 250m). Company B is much more highly geared (has more debt).