In our last installment, we examined the concept of return on equity and looked at one way to break the number apart into three separate components. ROE is one way to measure the return an investor receives on the capital invested in the business. By taking a year's worth of earnings and comparing it to the amount of shareholder equity on the balance sheet, you get a measurement of how much was returned for every dollar of equity the business has created.

As we saw in the last article, though, by manipulating the equation that defines ROE, you can isolate the three key tools that management has at its disposal to affect the returns of the business: pricing (earnings / sales), asset management (sales / assets), and financial leverage (assets / shareholder equity). ROE then becomes a measure not simply of how much of a return the company is generating from the equity it has created, but also of how successfully management has been at running the corporation.

Profit margin (pricing)
Pricing a product or service to create profits and volume is crucial to the success of any company. How well would Coca-Cola have fared had it decided that soda should be sold in 8-gallon jugs at $20 apiece? The container might have cost less as a percentage of the overall price, but the average motorist stopping by a convenience store wouldn't have room in the car for a big vat of soda. Purchases would have been restricted to home use, parties, and various entertainment establishments.

Pricing has become the realm of marketing. Nowadays, balancing profitability against volume is the bailiwick of market researchers, promotion gurus, and hard-nosed corporate executives. Yet all of the sales volume in the world is meaningless to shareholders if the company can't turn a profit. So pricing a product to be as profitable as possible and to generate stable sales growth is the holy grail of sales and marketing groups across the business world. The profit margin is one of the easiest ways to assess whether this group is meeting the profitability test.

The profit margin is the money left over after paying all of the costs of running the business. Calculating it is simple a matter of dividing earnings (or profits) by sales, both measured over the same time period. Managements that increase the profit margin are controlling costs, either by squeezing efficiencies out of the business or cutting out unprofitable ventures. Although managements can cut costs too far -- they can eliminate necessary research and development spending, for instance -- a higher profit margin generally means a higher ROE.

The profit margin is also an expression of the amount of competition inherent in the business. Competitive industries such as grocery stores and discount chains tend to have a very low profit margin, since getting into those businesses is fairly easy. On the other hand, railroads, which operate as semi-monopolies on large-scale traffic routes and deliver bulk commodities, tend to have significantly higher profit margins. A high profit margin typically indicates that a company either has a highly proprietary good or service, possibly one that's "branded" and therefore able to carry a price premium. Or it could mean that the company is in a business where it has a monopoly or is part of an oligopoly over a particular type of good or service.

Without some kind of moat around the basic business, new competitors can crunch a profit margin pretty quickly. Conversely, the more difficult it is for a new company to compete against an established business, the greater the potential profit margin for the existing company. In many cases, the existing company can temporarily lower prices in response to a threat of new competition and recoup lost revenue from other segments of its business.

A high profit margin rarely comes without either an entrenched business model or the semi-monopoly or oligopoly status that a railroad has. Railroads have limited competition where they own the tracks, and a huge, upfront capital investment has given many railroads a relative monopoly in some regions. However, as the next part of this series discusses at more length, if a high profit margin is complemented by a very low rate of asset turnover, the combination limits the total ROE. The vast majority of traditional, high-margin businesses are coupled with low asset turnovers -- in other words, they can do only a certain amount of business without incurring additional costs that would constrict the profit margin.

For more lessons on return on equity, follow the links at the bottom of our introductory article.

Coca-Cola is a Motley Fool Inside Value recommendation. The Motley Fool has a disclosure policy.