Last updated on 18 July, 2023

Our research delves into assessing the financial gain potential of a company’s stock, both in absolute sense and when compared to other companies within the same industry as well as the entire S&P500 index. We employ a meticulous examination of five specific metrics that shed light on a stock’s profitability:

Metric P1: ROE (Return on Equity) – This gauge signifies the financial return on the owner’s equity invested in the business.

Metric P2: ROA (Return on Assets) – This measure denotes the profit made relative to the company’s total assets, demonstrating how effectively these assets are utilized to generate earnings.

Metric P3: ROIC (Return on Invested Capital) – This metric conveys how efficiently a company uses its capital to generate profits, factoring in both debt and equity.

Metric P4: OPM (Operating Profit Margin) – This ratio signifies the percentage of revenue remaining after deducting operating expenses, providing insight into the company’s operational efficiency.

Metric P5: NPM (Net Profit Margin) – This ratio measures what percentage of each dollar of revenue the company keeps as profit after all expenses, taxes, and costs are accounted for.

We briefly discuss these five Profitability metrics below, with examples.

Return on Equity (ROE)

ROE is a significant financial ratio that quantifies a company’s ability to generate earnings from the investments made by its shareholders. It’s obtained by dividing the net income of the company for a given fiscal year by its shareholder’s equity:

Return on Equity (ROE) = (Net Income) / (Shareholder's Equity)

Net Income is the total earnings (or profit) of a company, calculated by subtracting total expenses, including tax and cost of goods sold (COGS), from total revenue. It represents the amount of money left over for the company’s owners (the shareholders) after all obligations have been met.

The general formula for calculating Net Income is:

Net Income = Total Revenue - Total Expenses

Total Revenue and Total Expenses are essential financial metrics appearing on a company’s income statement. They serve as a crucial foundation for assessing the profitability of a company over a specified timeframe.

1. Total Revenue: Often referred to as gross sales or simply sales, total revenue signifies the cumulative amount of money a company generates from its business activities, primarily from selling goods or providing services. The term “top line” is often used interchangeably with total revenue, as it’s positioned at the beginning of the income statement. The calculation of total revenue usually involves multiplying the price of goods or services sold by the number of units sold. In the case of companies with multiple business segments or product lines, revenues from all sources are combined to arrive at the total revenue.
2. Total Expenses: This captures all the costs incurred by a company during a specific accounting period. Expenses can be both direct, such as Cost of Goods Sold (COGS), and indirect, which includes overhead and operating expenses like salaries, rent, utilities, and administrative expenses. Additionally, it includes interest expenses on borrowed capital, if any, and taxes. It’s crucial to note that, in line with the matching principle of accounting, expenses are recognized and accounted for in the same period as the revenues they are associated with.

The equation Net Income = Total Revenue – Total Expenses provides the Net Income of the company, representing the remaining profits after accounting for all expenses from the total revenue. This is why Net Income is often referred to as the “bottom line”.

A company is considered profitable when its total revenue surpasses total expenses, resulting in net profit. On the other hand, if total expenses outstrip total revenue, the company incurs a net loss. This net income or net loss is a crucial barometer of a company’s financial health and its operational efficacy.

Shareholder’s Equity, also known as net assets or owner’s equity, is the residual interest in the assets of the entity after deducting liabilities. It represents the net value of a company — that is, what the shareholders would theoretically own if all the company’s debts were paid and all its assets were liquidated. Shareholder’s equity is a critical aspect of a company’s financial health, demonstrating the net value held by the shareholders. The general formula for calculating Shareholder’s Equity is:

Shareholder's Equity = Total Assets - Total Liabilities

Total Assets and Total Liabilities are critical constituents of a company’s balance sheet, providing a snapshot of its financial standing at a specific moment. Let’s examine each of these elements:

1. Total Assets: In essence, this term encompasses all the valuable properties or resources owned or managed by a company. These assets are split into two categories – current and non-current. Current assets are expected to be liquidated into cash within one fiscal year or one operational cycle, depending on which is longer. Typical examples include cash and cash equivalents, inventory, and accounts receivable. On the other hand, non-current assets, also known as long-term assets, are not expected to be liquidated within a single fiscal year or operational cycle. Examples include property, plant and equipment (PP&E), long-term investments, and intangible assets like patents or trademarks.
2. Total Liabilities: This refers to all the financial obligations that a company is accountable for, such as loans, supplier payments, employee salaries, taxes, etc. Similar to assets, liabilities can be categorized as current and non-current. Current liabilities are those debts or obligations that are anticipated to be fulfilled within a year or operational cycle. These can include accounts payable, accrued liabilities, and short-term debts. Non-current liabilities, otherwise known as long-term liabilities, are those obligations that extend beyond a year or an operational cycle. Examples include long-term loans, lease commitments, and pension-related obligations.

Accordingly, we can calculate the Shareholder’s Equity as:

Shareholder's Equity = Total Assets - Total Liabilities

The ROE is usually expressed as a percentage. A higher percentage is generally viewed favorably, indicating that the company is using shareholder’s equity effectively to create profits.

The Importance of ROE in Fundamental Analysis / Value Investing: ROE is an integral measure of a company’s financial efficiency, commonly employed in fundamental analysis and value investing for the following reasons:

Efficiency: ROE provides an insight into how effectively a company is utilizing its shareholder’s equity to generate profits. A higher ROE often implies superior management and the efficient use of the funds invested by shareholders.

Profitability: ROE serves as a benchmark to compare a company’s profitability against its competitors. A company with a higher ROE than its rivals may be more efficient at generating returns.

Growth: Companies demonstrating a consistently high ROE are often capable of maintaining their growth rates. They are likely to be profitable in the long term, which could lead to an increase in the share price over time, thus becoming appealing targets for value investors.

Benchmarking: ROE proves useful in comparing the profitability of one company against other firms within the same industry or the broader market average. This comparison can guide investors in determining which stocks to include in their portfolios.

Example — ROE of Apple (AAPL) in 2020

For illustration, we can use rounded-off figures from Apple Inc.’s Fiscal Year 2020:

1. The total revenue for Apple during this period was about $274.5 billion.
2. The total costs and expenses, which include COGS of $169.6 billion, operating expenses of $34.9 billion, and other expenses and taxes, amounted to approximately $217.1 billion.

By applying these figures to the Net Income equation:

Net Income = Total Revenue – Total Expenses

We can calculate that Apple’s net income for Fiscal Year 2020 was around $57.4 billion:

Net Income = $274.5 billion – $217.1 billion = $57.4 billion

This indicates that, after fulfilling all financial obligations and covering all expenses, Apple managed to retain about $57.4 billion as net profits.

The shareholders’ equity for Apple, based on the same fiscal year data, stood at approximately $65.3 billion. In a hypothetical scenario where Apple would need to liquidate all its assets and clear all its debts, this is the amount that theoretically would be distributed among the shareholders. This number essentially represents the residual ownership interest in the company, held by the shareholders, after all obligations are met.

Now let’s calculate the Return on Equity (ROE) for Apple for the Fiscal Year 2020. The ROE is calculated by dividing the net income by the shareholders’ equity:

ROE = Net Income / Shareholder’s Equity

Substituting the previously calculated values:

ROE = $57.4 billion / $65.3 billion = 0.879 or 87.9%

This result signifies that Apple generated an impressive return of 87.9% on the shareholders’ equity invested in the company during Fiscal Year 2020, indicating a high level of efficiency in generating profits and creating shareholder value.

Return on Assets (ROA)

Return on Assets (ROA) is a financial metric that shows the percentage of profit a company earns in relation to its total assets. It provides insight into how effectively a company is converting the money it has invested in assets into net income. In essence, the ROA gives investors an idea of how efficiently management is using the company’s assets to generate profits.

The formula for ROA is:

ROA = Net Income / Total Assets

As the formula suggests, the ROA is calculated by dividing the net income of a company by its total assets. The net income is derived after all expenses, taxes and costs have been subtracted from the company’s total revenue.

“Total Assets,” a key term on a company’s balance sheet, embodies all of a company’s possessions that have quantifiable financial value. It provides a snapshot of a company’s financial standing, demonstrating its resources for generating revenue and potential growth.

Total Assets are often divided into two primary categories:

1. Current Assets: These are short-term resources, predicted to be liquidated into cash, used, or sold within one fiscal year or an operating cycle. They encompass cash and cash equivalents, accounts receivable, inventories, marketable securities, and prepaid expenses. Current assets signify the liquidity of a company and its ability to meet short-term obligations.
2. Non-Current Assets: Also known as long-term assets, these are expected to yield economic benefits beyond the span of one year or one operating cycle. Tangible assets (like property, plant, and equipment – PP&E) and intangible assets (like patents, copyrights, and goodwill) fall under this category. Additionally, non-current assets include long-term investments that a company intends to hold for several years.

The total value of current and non-current assets constitutes a company’s Total Assets. It represents the cumulative wealth of resources that a company can leverage to generate revenue, grow, and invest in new opportunities.

Example — ROA of Apple (AAPL) in 2020

The Return on Assets (ROA) for a company like Apple Inc. can be ascertained using its Net Income and Total Assets. From the data we’ve previously discussed, we identified Apple’s Net Income for the Fiscal Year 2020 to be about $57.4 billion.

For illustrative purposes, we can assume a hypothetical figure for Apple’s total assets. Suppose we consider Apple’s total assets for the Fiscal Year 2020 to be $323.9 billion.

Applying these values to the ROA formula, which is:

ROA = Net Income / Total Assets

ROA = $57.4 billion / $323.9 billion = 0.177 or 17.7%

From this calculation, we can infer that for each dollar’s worth of assets it held during Fiscal Year 2020, Apple was successful in generating a net profit of approximately 17.7 cents.

Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is a financial performance metric illustrating the effectiveness with which a company utilizes the funds invested in its operations to generate earnings. It serves as a gauge for a company’s ability to create value from its capital investments.

At a conceptual level, ROIC measures the financial returns a company produces for every unit of capital employed. A higher ROIC value indicates that the company is more efficient at converting its capital into profits. This efficiency could stem from various factors like effective cost controls, operational proficiency, or strategic capital allocation decisions.

The formula for calculating ROIC is as follows:

ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital

Here’s what each term signifies:

1. Net Operating Profit After Tax (NOPAT) is an approximation of the profits a company could potentially accrue if it had no financial leverage (debt). It captures earnings derived from the company’s primary business operations after accounting for taxes, but prior to interest expenses and the servicing of debt.
2. Invested Capital refers to the total monetary resources that have been committed to the business. This figure is typically calculated by adding up the company’s equity and interest-bearing debt, then subtracting cash and cash equivalents. It embodies the funds actively deployed by the company in its operations.

In summary, ROIC presents a holistic view of profitability by considering both the operating profit and the capital employed by the company. By quantifying the returns a company generates on each dollar invested in it, ROIC serves as a useful comparative tool for assessing the profitability of companies across different sectors.

Profit Margin

The Gross Profit Margin, Operating Profit Margin, and Net Profit Margin are key indicators of a company’s financial health and efficiency, each offering a unique view of the firm’s profitability at different stages of operation.

Gross Profit Margin

The Gross Profit Margin illustrates a company’s performance at the most basic operational level, showcasing the efficiency of production. It represents the proportion of each dollar of revenue that the company retains after accounting for the direct costs incurred during the production of goods or services. These direct costs, also known as the Cost of Goods Sold (COGS), include direct labor and direct material costs.

Mathematically, it’s calculated as: Gross Profit Margin = (Gross Profit / Revenue) x 100%

Imagine a firm that reports a gross profit of $500,000, calculated from a total revenue of $1,000,000 minus COGS at $500,000. The Gross Profit Margin would then be (500,000 / 1,000,000) x 100% = 50%.

Operating Profit Margin

Moving further down the income statement, the Operating Profit Margin is used to gauge the efficiency of the company’s operations and pricing strategy. This margin reveals the percentage of revenue that remains after accounting for both variable and fixed operating costs such as wages, raw materials, rent, and insurance.

It’s computed as: Operating Profit Margin = (Operating Profit / Revenue) x 100%

Suppose a company with a revenue of $1,000,000 has an operating profit, or Earnings Before Interest and Taxes (EBIT), of $200,000. Its Operating Profit Margin equates to (200,000 / 1,000,000) x 100% = 20%.

Net Profit Margin

Finally, the Net Profit Margin comes into play. This measure represents the final proportion of revenue that the company retains as profit, after settling all obligations including taxes, COGS, operating expenses, interest, and other costs.

This is calculated as: Net Profit Margin = (Net Income / Revenue) x 100%

As an example, a firm with a revenue of $1,000,000 and a net income of $100,000 would have a Net Profit Margin of (100,000 / 1,000,000) x 100% = 10%.

These three profitability metrics combined provide a well-rounded view of a company’s financial performance. While the Gross Profit Margin shows the efficiency of the production process, the Operating Profit Margin gives an insight into the operational efficiency, and the Net Profit Margin accounts for all expenses and income, reflecting the firm’s overall profitability.

Example — Profit Margin of Apple (AAPL) in 2020

We illustrate the profit margins using the case of Apple Inc. The figures are estimates and have been simplified for ease of understanding. They correspond to Apple’s Fiscal Year 2020:

1. Revenue stood at around $274.5 billion
2. Cost of Goods Sold (COGS) was roughly $169.6 billion
3. Operating Expenses amounted to nearly $34.9 billion
4. Net Income was about $57.4 billion

Let’s use these figures to compute the profit margins:

The Gross Profit Margin is determined by subtracting the COGS from Revenue, then dividing by Revenue, and multiplying by 100%. For Apple, the gross profit (Revenue – COGS) would be $274.5 billion – $169.6 billion, equaling $104.9 billion. Thus, the Gross Profit Margin calculates to ($104.9 billion / $274.5 billion) x 100%, which is approximately 38.2%.

The Operating Profit Margin involves calculating the operating profit (or Earnings Before Interest and Taxes, EBIT), which is the Gross Profit minus Operating Expenses. In Apple’s case, this equals $104.9 billion – $34.9 billion, giving us $70 billion. The Operating Profit Margin is then ($70 billion / $274.5 billion) x 100%, working out to around 25.5%.

The Net Profit Margin is determined by dividing the Net Income by Revenue, and then multiplying by 100%. For Apple, this computes to ($57.4 billion / $274.5 billion) x 100%, equating to approximately 20.9%.

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