Evaluating stocks : Profitability

Evaluating stocks

Profitability

Return on Equity

Return on equity (ROE) is defined as net profit divided by the average common equity for the most recent financial year. The ratio helps understand number of units of profit generated per unit of money invested in the company. Higher the ROE better the utilisation of shareholders money

Common equity refers to the money invested in the company by common shareholders. It is important to ensure that money invested during the financial year does not distort the ROE number. Hence average common equity, i.e average of common equity at the beginning and end of the financial year is considered for calculation

The current year ROE number needs to be compared with the historical ROE numbers of the company to understand whether it is efficiently utilising capital. If the ROE numbers are trending up, it is a positive sign

ROE numbers of different companies operating in the same sector can also be compared with each other

5Y Avg Return on Equity

5Y Avg Return on Equity is the average of the annual ROE number over the previous 5 financial years

As discussed above, ROE helps understand number of units of profit generated per unit of money invested in the company. Higher the number better the utilisation of equity capital
When analysing 2 or more companies, comparing ROE numbers for a single year will not suffice. It is possible that profits have increased or decreased substantially due to extraordinary profits or losses in a particular year, thereby falsifying the picture. Suppose we are comparing 5 years of data for 3 companies, we will have to inspect 15 (3*5) data points which can be cumbersome

Instead, using average ROE is more simpler as well as eliminates the possibility of data distortion due to one-off earnings or losses   

Return on Assets

Return on assets (ROA) is defined as net profit divided by the average total assets for the most recent financial year.  The ratio helps understand number of units of profit generated per unit of assets owned by the company. Higher number indicates better asset utilisation. In order to ensure assets bought during the financial year does not distort the ROA number, average of assets at the beginning and ending of the financial year is used
An increasing trend in ROA indicates improved efficiency in managing the assets of the company. ROA’s of 2 or more companies operating in the same sector can also be compared with each other

5Y Avg Return on Assets

5Y Avg Return on Assets is the average of the annual ROA number over the previous 5 financial years. ROA helps understand number of units of profit generated per unit of assets owned by the company, higher the number better the asset utilisation
Averaging historical ROA numbers reduces the number of data points that needs to be studied, as well as smooths the series of numbers and eliminates any distortion due to one off profit or loss

Net Profit Margin

Net Profit Margin is defined as net profit divided by the revenue of the company for the most recent reported    financial year. The ratio explains number of units of profit earned for every 100 units of revenue. For example if the net profit margin is 12%, it means that for every Rs.100 revenue, Rs.12 was converted into profit. Obviously higher the net profit margin the better
For the purpose of analysis, one should compare the current year net profit with historical numbers to understand whether the company is operating efficiently. Net profit margin of 2 or more companies, operating in the same sector, can also be compared with each other to select the more profitable one

5Y Avg Net Profit Margin

5Y Avg Net Profit Margin is the average of the net profit margin number over the previous 5 financial years. As discussed above, net profit margin explains number of units of profit earned for every 100 units of revenue
Averaging historical numbers smoothes any distortions in net profit margin due to one off expense or income. It also allows easier comparison of number of years of data points for multiple companies

Return on Investment

Return on Investment (ROI) is defined as net income divided by the average of shareholders equity, long term debt and other long term liabilities for the most recent financial year. Average of shareholders equity, long term debt and other long term liabilities is calculated by considering the average of the aforementioned items at the beginning and ending of the financial year. ROI is an efficiency indicator that helps understand the number of units of income earned for every Rs.100 investment

For example, let’s assume the operating income of a company is Rs.30, long term debt is Rs.25 and shareholders equity is Rs.150. The total capital is the sum of long term debt and shareholders equity, hence 25+150 = Rs.175. ROI will be calculated as 30 / 175 = 17.1%. This indicates that the company earned Rs.17.1 for every Rs.100 investment
A company’s current ROI can be compared with its historical returns’, ROI of companies operating in the same sector can also be compared with each other

5Y Avg Return on Investment

5Y Avg Return on Investment is the average of ROI for the most recent 5 financial years. As explained above, ROI is an efficiency indicator that helps understand the number of units of income earned for every Rs.100 investment

Operating Profit Margin

Operating Profit Margin is defined as operating profit divided by the revenue of the company for the most recent reported financial year. Operating profit indicates the amount of revenue left over after paying for operating costs of the company like cost of goods sold, salaries, selling and distribution expenses etc

The ratio indicates the number of units of operating profit earned for every 100 units of revenue. For example if the operating profit margin is 21%, it means that for every Rs.100 revenue, Rs.21 was converted into operating profit. The ratio allows us to understand how strong the operations of the company are and how much money is leftover to pay interest costs. Obviously higher the operating profit margin the better

For the purpose of analysis, one should compare the current year operating profit with historical numbers to understand whether the company continues to operate efficiently. Operating profit margin of 2 or more companies, functioning in the same sector, can also be compared with each other to select the more efficient one

5Y Avg Operating Profit Margin

Average operating profit margin – 5 year is the average of the operating profit margin over the previous 5 financial years

Operating profit margin helps understand the number of units of operating profit earned for every Rs.100 revenue

Averaging historical numbers smoothes any distortions in operating profit margin due to sudden spike or drop in operating costs of the company. It also facilitates easy comparison of number of years of data for multiple companies