The Role of Profitability Ratios in Stock Market Evaluation
Overview
Profitability ratios are financial indicators which the investors use to analyze a company’s health in terms of profit generations with respect to its revenue, assets , equity and other financial parameters. Profitability ratios provide information about a company’s financial health, operational efficiency and its overall performance. Investors use profitability ratio to analyze the fundamentals of the company before investment.
Introduction
Profitability ratios is the measurement of the company’s financial health to generate profit and manage operations . The most significant profitability ratios are
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Gross Profit Margin
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Operating Profit Margin
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Net Profit Margin
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Return on Assets (ROA)
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Return on Equity (ROE)
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Return on Capital Employed (ROCE)
Significant Profitability Ratios
Gross Profit Margin
Measures the efficiency of a company’s production processes and cost management.
Gross profit margin measures the revenue generated by a company against the cost of goods sold or net sales in percentage. Gross Profit margin indicates how the company is managing its production costs of goods or services relative to its sales.
Formula
Gross Profit Margin = (Profit Margin / Net Sales) * 100
Higher the percentage of gross profit margin, most efficient is the company’s ability to produce its goods or services.
Example
Consider a company ABC with net sales of Rs. 500000 and gross profit of Rs. 200000.
Then Gross Profit Margin = (200000 / 500000)*100 = 40%
Operating Profit Margin
Indicates a company’s efficiency in core business operations
Operating Profit Margin measures the revenue remaining after settling all costs incurred in production of goods or services( E.g.: wages, raw material cost etc. ) in percentage
Formula
Operating Profit Margin = (Operating Profit / Net Sales) * 100 where
Operating Profit = (Net Sales – COGS – Operating Expenses)
Or
Operating Profit Margin = (Operating Profit / Revenue) * 100
Operating Profit = (Revenue – Operating Expenses )
Higher the Operating Profit Margin, greater is the profit generated by the company through its operations.
Example
Consider a company ABC with Net Sales of Rs. 1000000, Cost of Goods Sold of Rs. 600000 and Operating Expenses of Rs. 200000.
Then
Operating Profit Margin = [(1000000 – 600000 – 200000) / 1000000] *100 = 20%.
Net Profit Margin
Reflects the overall profitability of the company after all deductions
Net Profit Margin measures the final profit or income earned by a company after paying all its expenses (operating expenses, CPGS , tax and interest). Net Profit margin indicates the actual profit made by a company.
Formula
Net Profit Margin = (Net Profit / Net Sales )*100
Net Profit or Net Income = Net Sales – Total Expenses
Higher the net profit margin , greater is the company’s profitability.
Example
Consider a company ABC with net sales of Rs. 1000000, COGS of Rs. 600000, operating expenses of Rs. 200000, Interest Expenses of Rs. 30000 and tax payable of Rs. 50000.
Net Profit = 1000000 – 600000 – 200000 – 30000 – 50000 = 120000
Net Profit Margin = (120000 / 1000000 )* 100 = 12%
Return on Assets (ROA)
Reflects how a company efficiently utilizing its assets to generate profit
Return on Assets measures how effectively a company utilizes its assets to generate its profit in percentage. It indicates how a company’s management utilizes its assets to generate profit efficiently.
Formula
Return on Assets = (Net Profit /Total Assets )*100
Higher ROA indicates greater efficiency and profitability of the company.
Example
Consider a company ABC with net profit of Rs. 50000 and Average total assets of Rs. 450000.
Return on Assets = (50000 / 450000) *100 = 11.11%
Return on Equity (ROE)
Reflects how a company efficiently utilizing its shareholder’s equity to generate profit
Return on Equity measures how efficiently the company utilizes its shareholder’s equity to generate its profit. It indicates how a company’s management utilizes its shareholder’s equity to generate its profit efficiently.
Formula
Return on Equity = (Net Profit / Shareholder’s Equity )*100
Shareholder’s Equity = Total Assets – Total Liability
Higher ROE indicates greater profit generation through equity investments.
Example
Consider a company ABC with its net profit of Rs. 500000 and average shareholder’s equity of Rs. 2250000 .
Return on Equity = (500000 /2250000)/100 = 22.22%
Return on Capital Employed (ROCE)
Reflects how a company efficiently utilizing its capital to generate profit
Return on Capital Employed measures the company’s ability to generate profit from its total capital in percentage. It indicates how a company is utilizing its profit to generate operating profit (EBIT)
Formula
Total capital = Total assets – Total liabilities
Or Total capital = Shareholder’s equity + long term debt
ROCE = (EBIT / Total capital )*100
Earnings Per Share
Reflects the share of profit available for each common shares
EPS measures the amount of profit allocated to investors of each common share.
Formula
EPS = (Net Income – Preferential stock dividend) / Weighted Average of Outstanding shares
Higher the EPS, greater is the financial strength of the company.
Example
Consider a company ABC , with net income of Rs. 2000000, preferential stock dividend of Rs. 200000, weighted average outstanding shares of 550000.
EPS = (2000000 -200000)/550000 = 3.27
Thus , for each share of common stock, the company has earned Rs.3.27.
Price to Book Ratio
Reflects the company’s value in the share market.
P/B ratio measures the company’s share market value against its book value. It indicates for each rupee of book value of the share, what is its market value equivalent. It indicates whether a company’s share is overvalued or undervalued.
Formula
P/B ratio = Market value of a shares / Book Value of a share
Book value of a share = Shareholder’s equity / total outstanding shares
Shareholder’s equity = total assets – total liabilities.
If the P/B ratio is less than 1, company’s shares are undervalued and if P/B ratio is greater than 1, company’s shares are overvalued.
Example
Consider a company with its share market price of Rs.50 each, total shareholder’s equity of Rs. 5000000 and total outstanding shares of 1000000 in number.
Book Value = 5000000 /1000000 = Rs. 5
P/B ratio = 50 / 5 = 10
For each Rs.1 of a share's book value, the market is ready to pay Rs.10 to buy it.
Application of Profitability Ratios in Stock Investment
Profitability ratio provides information about a company’s financial strength , ability of the company to generate profit and efficiency of its operation. Generally, higher the profitability ratio of a company, greater is its efficiency to generate profit and the attractiveness for investments
Profitability ratios help investors to compare profitability of different companies of the same industry.
Higher profitability ratio values in turn increases the value of P/E ratio, which in turn reflects the increase in company’s earnings and investors’ confidence.
Higher profitability ratio values indicate that a company has low risk which in turn boosts investors confidence.
Conclusion
Profitability ratios are an important tool to analyze a company’s financial strength. It indicates a company’s ability to generate profit by utilizing its available resources. Investors can make informed decisions which are available on Enrich Money. Enrich Money provides detailed analysis of each stock which helps investors immensely to make well informed investment decisions.
Frequently Asked Questions
What is the use of profitability ratio analysis in the stock market?
Profitability ratio analysis helps investors assess a company's ability to generate profit. It provides information about a company’s financial health and operational efficiency.
List the profitability ratios that are used in stock market analysis?
Commonly used profitability ratios include gross profit margin, net profit margin, return on assets (ROA), and return on equity (ROE).
How can gross profit margin influence investment decisions?
Gross profit margin indicates how efficiently a company produces its goods or services.
Why is the return on equity (ROE) important for stock market investors?
ROE measures how effectively a company uses shareholders' equity to generate profit.
What does high return on assets (ROA) indicate about a company?
A high ROA indicates that a company is efficiently using its assets to generate profit.
Disclaimer: This blog is dedicated exclusively for educational purposes. Please note that the securities and investments mentioned here are provided for informative purposes only and should not be construed as recommendations. Kindly ensure thorough research prior to making any investment decisions. Participation in the securities market carries inherent risks, and it's important to carefully review all associated documents before committing to investments. Please be aware that the attainment of investment objectives is not guaranteed. It's important to note that the past performance of securities and instruments does not reliably predict future performance.
