Long-term investors buy shares of a company with the expectation that the company will produce a growing future stream of cash or earnings even when investing in emerging industries such as the Internet sector. Profits point to the company's long-term growth and staying power. There are a number of interrelated ratios that help to measure the profitability of a firm.
Gross profit margin reflects the firm's basic pricing decisions and its material costs. The greater the margin and the more stable the margin over time, the greater the company's expected profitability. Trends should be closely followed because they generally signal changes in market competition.
Operating profit margin examines the relationship between sales and management-controllable costs before interest, taxes, and non-operational expenses. As with the gross profit margin, one is looking for a high, stable margin.
Profit margin is the "bottom line" margin frequently quoted for companies. It indicates how well management has been able to turn revenues into earnings available for shareholders. For our example, about 4½ cents out of every dollar in sales flows into profits for the shareholder.
Industry comparisons are critical for all of the profitability ratios. Margins vary from industry to industry. A high margin relative to an industry norm may point to a company with a competitive advantage over its competitors. The advantage may range from patent protection to a highly efficient operation operating near capacity.
Return on total assets examines the return generated by the assets of the firm. A high return implies the assets are productive and well-managed.
Return on stockholder's equity (ROE) takes this examination one step further and examines the financial structure of the firm and its impact on earnings. Return on stockholder's equity indicates how much the stockholders earned for their investment in the company. The level of debt (financial leverage) on the balance sheet has a large impact on this ratio. Debt magnifies the impact of earnings on ROE during both good and bad years. When large differences between return on total assets and ROE exist, an investor should closely examine the liquidity and financial risk ratios.
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