Profitability Ratios Based on Original Investment

The standard test of profitability involves net margin (net income compared to sales) or earnings per share (net profit expressed on a per-share basis). Another way to look at the idea of profitability is to consider how the shareholders' investment grows over time. With this in mind, the following section presents another category of ratios: profitability on the basis of the original investment.

Return on Equity

In most forms of investment, the standard calculation involves a comparison between the income from the investment and the amount actually invested. In other words, you invest $1,000 in the purchase of stock and you receive $1,100—a margin of 10 percent. Or you buy a house for $150,000 and later sell it for $180,000, for a margin of 20 percent.

Only when it comes to corporate financial statements is this general rule not followed. The standard concept of margin and return is based on the business activity rather than on investment value. However, there are two levels of analysis going on at the same time. As a fundamental analyst, you need to keep these two levels separate in your mind.

KEY POINT

Remember that corporate profits—the usual measurement of success—-are not necessarily the same as return on your investment, which consists of dividends and higher market price. The two measurements do not always track together.

First is the standard evaluation that occurs in corporations' accounting departments. Business success is invariably measured in terms of sales. How much profit was generated? How did that compare to last year? Why wasn't it more? Dollars are the scorekeeping medium in business. And because the study and reporting of financial results is universal and standardized, this has also become the basis for most fundamental analysis—appropriately so.

The second, more subtle, evaluation is return on your personal investment. Why is this more subtle? First of all, in the preoccupation with fundamental analysis based on performance measured against sales volume, and financial strength judged by assets, it is easy to overlook the all-important bottom line for you, the investor. Ultimately, it is the return on your capital, not the corporation's capital, that is important to you. What good does it do you if the corporation's profits set new records if you still show a loss when you sell your stock?

The formula for calculating year-to-year overall return on investment is different if you continue to hold a stock than it would be if you had sold. After a sale, the calculation involves a comparison between the purchase price and the sale price. In the most simplistic form, the difference is a profit (selling price is higher than the purchase price) or a loss (selling price is lower than the purchase price). In more complex forms of analysis, you might add in dividend receipts to arrive at total return. If you also consider the length the investment was held, you would also divide total return by the number of years to arrive at annualized return. This is an important distinction to make from total return.

Example: You have two separate investments, one which you purchased ten years ago and one which you purchased only one year ago. You sold both investments this year. The older of the two yielded 58 percent in total return; the newer investment yielded a total return of 8 percent.

This example demonstrates the importance of annualizing total return. It helps to make your comparisons truly comparative. Considering that you had the one investment for ten years, the average annualized margin was 5.8 percent. In comparison, the newer investment yielded 8 percent, which was higher on the annual basis.

Annualized return is also helpful in calculating comparative returns on investments held for less than one full year.

Example: You sold two stocks this year. Both yielded 11 percent in total return. The first was held for 13 months, while the second was held for only 8 months.

To compute annualized return for partial years, first divide the total return by the number of months held, and then multiply by 12 (months). The result is the equivalent annual margin.

Example A:

11 percent total return, 13 months:

.846 x 12 (months) = 10.15% annualized return

Example B:

11 percent total return, 8 months:

.615 x 12 (months) = 7.38% annualized return

As you can see, annualizing returns for investments held over different periods can clarify your profit picture. One of the most important rules for fundamental analysts is to ensure that the conclusions they draw are always based on truly comparative information.

The analysis of profits on stocks already sold is relatively easy, because you know the dollar amounts involved as well as the holding period. However, you may also want to calculate the return-to-date on investments you currently hold, as a means to determine whether the decision to hold the investment makes sense. If the rate of return on your investment is below your expectation level, that alone might be enough to trigger a sell decision. Thus, it is always wise to calculate your total annualized return based on the question: What would the outcome be if I sold today?

Another twist on this form of analysis is to ask yourself what shareholders are earning as a return on their investment in the company. This is not the same as the analysis of your investment in the stock, meaning comparing purchase price to sales price of the stock. A study of shareholders' return has to compare net profits from operations, to average net worth for the latest year. The ratio for return on equity is shown in Figure 6.8.

FIGURE 6.8 Return on Equity (rounded to one decimal)

This ratio shows not the volatility of the market price of the stock, but how the investment in capital stock—becoming a shareholder in the corporation—performed on the basis of income generated during the year. In truth, return by way of net income is only the current income portion of the investment. In the longer-term sense, it is the market value of stock that will determine return on equity. This ratio enables you to develop a way to monitor operational performance by the corporation based not so much on sales growth, but on the relationship between net income and equity capital.

KEY POINT

Ultimately, return on equity will mean much more to you as an investor than the corporate measurement of net margin on sales.

Average net worth is important to calculate, because using only the year-end figure ignores current additions to retained earnings from net income, as well as any new stock issued during the year. To compute, add the total net worth at the beginning of the year to total net worth at the end of the year and divide the total by two.