How to Assess Profitability

To try to determine whether a company’s stock is worth its current share price, investors use a variety of ratios. These ratios help put a company’s profitability in context by comparing the company to its peers in the same industry. For example, if you know the Coca-Cola Company is profitable, you also need to know how its profitability compares to that of other beverage companies, such as PepsiCo Inc. and Cadbury Schweppes PLC. Among the most popular ratios and statistics investors use to analyze profitability are the price/earnings ratio, the return on sales ratio, the payout ratio, and various profit margins.

The P/E ratio divides the company’s share price by its earnings per share (EPS), or the total earnings divided by the total number of shares outstanding (shares held by investors).

A company with a share price of $20 per share and an EPS of $2 has a P/E of 10.

Though the average P/E ratio for all stocks historically falls between 15 and 25, the significance of the ratio depends on the company’s particular industry and on overall economic conditions at a given time. For example:

One effective way to get a sense of whether a tech or shipping company offers good value, for example, is to compare its P/E to that of its direct competitors or, better yet, to the average P/E ratio of the entire industry. One way to find out an industry’s average P/E is by using the Yahoo! Finance Industry Browser, at biz.yahoo.com/ic.

The return on sales (ROS) ratio is used as a measure of a company’s operational efficiency. By analyzing the income statement numbers using ROS, you can gauge how much profit a company brings in for every dollar of sales it makes. To calculate ROS, consult the company’s income statement to find its net profit and the total amount the company paid in taxes. Add the amount the company paid in taxes to total net profits and divide the result by sales (revenue) to get the ROS:

As with the P/E ratio, the best way to get a sense of the significance of a company’s ROS is to compare the ROS to that of direct competitors or to the average ROS of the entire industry. When comparing two companies in the same industry, the company with the higher ROS number has a higher degree of operational efficiency.

The payout ratio measures the percentage of earnings that a company distributes to shareholders as cash dividends. To calculate the payout ratio, consult the income statement to find the total amount the company spent on cash dividends, then divide by net profits.

The payout ratio can help investors assess how a company’s dividend payouts compare to other companies in the same industry. Investors use this information to assess a company’s profitability and overall financial well-being. For example, if two companies in the same industry have vastly different payout ratios, investors might be wary of the company with the lower ratio. More specifically, they would investigate why that company has chosen to retain the cash that other companies in the industry pay out to investors as dividends. Unless they uncover a good reason for the discrepancy—such as significant capital expenditures that will boost the company’s future profits—they might suspect that the company’s profitability is too low to cover expenses and dividend payments together. Like all financial statistics, the payout ratio alone doesn’t suffice as support for investment decisions. It must always be considered in the context of the company’s other core fundamentals.

A profit margin expresses, as a percentage, the difference between what a company pays for a product or service and what it receives for selling that product or service. A company’s overall profit margin is equal to its net profit divided by its sales during a specific period of time. Though the overall profit margin gives a sense of how efficiently a company converts sales into profits, investors use the following three more focused versions of the profit margin to evaluate a company’s profitability: the gross margin, operating margin, and net margin.

The gross margin is a profit margin based only on sales and the cost of producing those sales. It divides gross profit by net sales (total sales, or revenues, minus expenses related to returns or discounts, if any):

Investors use gross margin to assess a company’s efficiency in producing and distributing its products or services. After determining the gross margin, compare it to that of other companies in the same industry. A higher gross margin indicates a greater degree of efficiency.

The operating margin helps investors evaluate how well a company controls costs by factoring in expenses, such as distribution and R&D, not directly related to the production and sales of a product. To calculate operating margin:

Companies with an operating margin above the industry average are typically better at controlling their cost of sales and operating expenses, which gives them advantages such as pricing flexibility during difficult economic times.

The net margin measures a company’s overall effectiveness at realizing net profits from sales. To calculate net margin, divide net profit by net sales or revenues:

Net margin is helpful in comparing companies within the same industry (the higher the margin, the better) and in assessing a company’s profitability year to year. Companies that maintain high net margins relative to the competition over a period of a years aren’t just lucky—they’re consistently more effective at generating profits from sales.