Profitability: how much a company earns on what has been invested

Profitability is the ratio of profit to the base that produced it, and the whole meaning of the measure is hidden in the denominator: it is the denominator that answers the question "whose money was this earned on". Profit to equity (ROE) describes the return on the shareholder's money. Profit to assets (ROA) is the return on everything the company has at its disposal, including what it has borrowed. Profit to invested capital (ROIC) is the return on the capital actually employed in operations, without the cash cushion and other non-core balances. Profit to revenue (margin) is how much is left from each rouble of sales. These are different questions, and a stock with a strong return on the owner's capital can be mediocre in terms of return on total capital: the difference is created by debt.

The denominator determines what you are measuring

The place to start is not with choosing the "right" ratio but with the question of whose money you are interested in. If you are a shareholder working out what return a stake in the equity brings, that is ROE. If you want to understand the quality of the business itself, without mixing it up with management's decision to borrow or not to borrow, that is ROIC or ROA. If you are interested in the company's ability to hold its prices and control its costs, that is margin at its various levels: gross, operating, net. The gap between gross and operating margin shows the weight of administrative and selling expenses; the gap between operating and net margin shows the weight of interest and taxes.

To put together any of these ratios you need both financial statements: profit is taken from the income statement, the base from the balance sheet. Hence the technical detail that trips people up most often: profit is a flow over a period, capital is a snapshot at a date. The correct approach is to calculate the base as the average balance over the period, otherwise a large share issue or buyback at the end of the year will distort the result.

ROE: why a high figure is not always good news

ROE breaks down into several multipliers: margin, asset turnover and financial leverage. This decomposition is useful precisely because it shows the source of the return. One business earns through a high markup with slow turnover, another through a thin margin with fast turnover, a third simply through heavy leverage. Arithmetically the result may be the same; in terms of reliability it is not: leverage increases the return in good years and amplifies the loss in bad years in the same proportion.

What to compare the result with

Profitability says nothing on its own — it works only in comparison. There are several useful reference points, and each answers its own question.

Step 1 — compare it with the cost of capital. A business creates value only when the return on invested capital exceeds the price of that capital; a return below the price of money means that growth in scale destroys value, even if profit in absolute roubles is rising. A rough guide to the lower bound is the yield on OFZ of comparable maturity.

Step 2 — compare it with competitors in the same industry. The normal level of profitability for a retail chain, a steelmaker and a bank differs fundamentally, because the structure of assets and the regulation differ. Cross-industry comparison is almost always meaningless. Comparable data on issuers are gathered in the financial reports section, and the profiles of the securities in the list of stocks.

Step 3 — compare the company with itself over the course of the cycle. In a commodity business profitability moves together with the price of the commodity, and the peak value at the top of the cycle is not the norm. What you need to look at is not a point but the trajectory through a full cycle.

Where profitability gets distorted

The denominator is an accounting figure, and it is sensitive to accounting decisions. A revaluation of fixed assets increases equity and mechanically understates ROE. A share buyback reduces equity and overstates it. Goodwill accumulated from past acquisitions inflates assets and weighs on ROA, while writing it off sharply "improves" the following year's figure. Non-recurring items — the sale of an asset, a foreign-exchange revaluation, a legal settlement — end up in profit but have nothing to do with the operating return, so they are best set aside. Stakes in associates bring in profit that is recognised in the statements under the equity method, although the corresponding assets are not included in the consolidated balance sheet: the numerator and the denominator no longer correspond to each other.

A separate point: profitability does not apply to funds at all. A fund has no business of its own and no equity of its own that it invests — its result is set by the index and by the expenses of the management company; the relevant metric there is a different one, see tracking error.

How this relates to the price of the security

Profitability describes the business, not your return: a business that is strong on ROIC but bought too expensively gives the investor little. The link runs through valuation: other things being equal, the higher the sustainable return on capital, the larger the premium the market is willing to pay for that capital. That is why it makes sense to read a valuation ratio alongside profitability — for example, 3,77 on the page for {{instrument:SBER}}. And remember that what is earned in nominal roubles has to be set against inflation — this is covered in real return.

A last caveat, in all honesty: if an issuer has no comparable statements for a run of periods, there is no profitability to interpret either. Calculating a ratio across non-comparable periods or for one random date is worse than admitting that there is not enough data. The definitions of the concepts mentioned here are gathered in the glossary.