Investing is really about one thing, and one thing only: the ability to participate alongside the profit generating ability of a business. With profits at the very foundation of investing, it means that investors need to have a firm grasp on the ability of a company they're investing in to turn a profit. The best way to gauge how well a company is doing in that regard is to take a closer look at its profitability ratios to see how that company really stacks up. There are three profitability ratios in particular that every investor really should know.
What are profitability ratios?
By definition, profitability ratios measure a company's ability to generate profit for the owners. There are dozens of profitability ratios that could be used, each measuring a company's profit against a desired benchmark such as sales, assets, or equity. However, the key to a profitability ratio isn't the number itself, but how that number compares in relation with a company's peers or its own history.
The foundational profitability ratio
While there are a number of profitability ratios that measure a company's ability to generate profit from the sales or services it provides, one of the most important is the net profit margin. It tells us what percentage of revenue a company keeps after all its bills are paid. The formula is:
Net Margin = (Net Income or Loss) / Sales.
While the higher this number is, the better, there is no gold standard. A good net margin in the retail sector would be an awful net margin for a software company. That's why this number shouldn't be looked at in isolation, but should be compared to a company's peer group as well as its own history. For example, here's a look at the profit margins of three of the top energy industry equipment manufacturers over the past five years.
As that chart notes, National Oilwell Varco has consistently had the highest profit margin in the sector. This tells us that it does a better job than its two closest peers of converting revenue into profits for its investors, as it's turning $7.39 of every $100 in sales into profit, which is a buck more than its two peers. However, by looking out over a longer period, we can also see that its profit margin has fallen this year, which would be a red flag worthy of more research to see if the company is in trouble, as both Cameron and FMC Technologies haven't seen their profit margins fall as steeply this year.
Turning profits into returns
Two other important profitability ratios for investors to know are both returns-based ratios that measure a company's ability to create wealth for shareholders. They are return on equity and return on assets.
Return on equity is simply net income divided by shareholders' equity. It measures is a company's ability to turn an investor's equity into profit. The higher the return on equity, the better job a company is at optimizing the investment made on shareholders' behalf.
Return on assets, on the other hand, measures a company's ability to turn assets such as cash, buildings, equipment, or inventory into more assets. The formula to calculate it is:
Return on Assets = (Net Income + Aftertax Interest Expense) / (Average Total Assets).
As with any return, the higher this number the better. However, it, too, needs to be taken into the context of a company's peer group as well as its own history.
For an example, we'll use our previous trio of oilfield equipment makers:
Here we see that FMC Technology is the clear leader. Its returns on equity and assets are both well above its two peers. What this tells us is that the company is doing a far superior job at turning equity and assets into profitability. It suggests that FMC Technology has the ability to grow its profit at a faster clip than its rivals. However, its return has slipped over the past five years, which is something investors should dig into a bit more to see if there are any issues that could hamper future profit growth.
Profitability ratios show investors how well a company is doing at making a profit, which is what drives investment returns. For example, investors looking for value or income might look for a high net income margin relative to its peers or history while those looking for growth would look at returns-based profitability ratios. Therein lies the key to profitability ratios is that they can't be viewed in isolation but need to be compared to a company's peers as well as its own history.
Matt DiLallo owns shares of and The Motley Fool owns and recommends National Oilwell Varco. The Motley Fool recommends FMC Technologies. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.