Making Sense of Profits Using Profitability Ratios

Making Sense Of Profits Using Profitability Ratios Splash image

Long-term investors buy shares of a company with the expectation that the company will produce a growing future stream of cash or earnings.

Profits point to the company’s long-term growth and staying power.

But “more” profits aren’t necessarily better than “less.” Oil companies have been in the headlines for generating “record profits” that are larger than any other firms in U.S. history. But from an investor’s standpoint, that doesn’t necessarily make them the most profitable firms.

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David Fox from New Mexico posted about 1 year ago:

Then there is ROIC--Return on Invested Capital which Elizabeth Collins, in a 10-27-05 Morningstar Stock Strategist piece said, "My favorite financial ratio is--hands down--return on invested capital or ROIC. I think it is ten times better than [sic] ROA or ROE, and net profit margin doesn't even come close."

That's because, she says, [ROIC] "single-handedy provides a quantitative answer to the question, Does this company have an economic moat? .... [and] Given how great the ROIC metric is, I wish there was a stock screener that would help me find companies with high ROICs, but unfortunately one doesn't exist.....ROIC is a measure of how much cash a company gets back for each dollar it invests..."

She points out these limitations: (1)NET INCOME is used as numerator in both calculations, but, she says there can be many things going on "below the line" that make an unprofitable company appear profitable. (2)ROE:by carrying high debt & repurchasing shares, management can increase leverage & thus ROE,"But either can produce an unreasonably high ROE that doesn't accurately represent the company's profitability." (3)ROA:"...companies can carry lots of assets that have nothing to do with their operations."

And so on. But, AAII, how about creating the missing ROIC screen?

AAII: How about creating an ROIC screen?

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