Evaluating Profitability with 5 Important Indicators

Many investors pay close attention to the profitability of stocks. Profitability can reflect whether a company is making money or not. Companies with strong profitability can gain more robust competitive advantages in their respective markets and potentially bring higher returns to investors.

So, how to measure the profitability of a company? Here are five of the most commonly used indicators for your reference.

Gross Profit Margin

It is calculated by dividing a company's gross profit by its total revenue. A company's gross profit equals its total revenue minus the cost of goods sold (COGS), which includes expenses such as material costs, manufacturing costs, and wages paid to workers.

Generally, a company with a gross profit margin higher than the industry average tend to have competitive advantages over its peers and might attract investors' attention.

Net Profit Margin

It is calculated by dividing a company's net income by its total revenue. It is a key indicator of a company's profitability, and it can also help evaluate how competitive the company is overall. Companies with a higher-than-average net margin tend to have a greater margin of safety in an economic downturn.

Return on Assets (ROA)

ROA is an overall profitability metric, calculated by dividing net income by average total assets. It measures how efficiently a company uses all of its assets to generate profits. Industry comparisons are needed as ROA varies across sectors. Generally, a company with an ROA of over 10% may be considered to be performing well.

Return on Equity (ROE)

ROE, a key profitability metric watched closely by most shareholders, is the ratio of net income to the average shareholders' equity. It measures how efficiently a company uses its net assets to generate profits, and reflects its net margin, ROA, and financial leverage. A company or a sector with a high ROE, usually over 20%, may suggest it has a strong competitive edge and may appear attractive.

EPS

Earnings Per Share (EPS) represents the net profit that can be allocated to each ordinary share of a company's stock. A higher EPS typically reflects greater profitability and attractiveness to investors. Wall Street analysts usually use this indicator to assess stock valuation and earnings potential, and also estimate its future trends. Typically, high-performing companies have a steadily rising EPS.

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