The heart of fundamental investing is numbers. Numbers are used to determine a stock’s value, a business’s risk, and the safety of our investment. More than other approaches, fundamental investing relies upon numbers to make decisions.
The easiest way to use numbers is through ratio analysis. There are many different ratios that cover every aspect of a company. To make the wealth of data accessible without overwhelming new investors, I will categorize these ratios and then highlight the most important ratios in each group.
The first set of ratios focus on profitability. Since when we buy a stock we purchase a stake in the business, profitability is very important. A company could have great products, fantastic management, and a conservative capital structure, but if it does not produce profit, it will not remain in business. As investors, we need to find companies with strong, improving profits in order to justify an investment.
The three ratios that best assess a company’s profitability are the gross profit margin, the operating profit margin, and the net profit margin. They can be applied on either a quarterly or annual basis, providing great flexibility. To calculate and understand each ratio, see the following:
1. Gross Profit Margin – The gross profit margin is calculated as follows:
(Sales – Cost of Goods Sold) / Sales
This ratio represents the difference between a company’s net sales, accounting for its inventory costs, and total sales. Investors should look for a high gross margin as a starting point for analysis.
2. Operating Profit Margin – The operating profit margin is calculated as follows:
(Sales – Cost of Goods Sold – Operating Expenses) / Sales
This ratio expands upon gross profit margin by including all operating expenses and represents the amount of profits received for operating the core business. As with all profitability ratios, the higher the number the better.
3. Net Profit Margin – The net profit margin is calculated as follows:
Net Income / Sales
This ratio represents the company’s bottom line. It expands upon operating profit margin by including all non-operating expenses, interest expense, and taxes. By removing these costs, investors see how much of each sales dollar generates into income for the business owners.
Profitable businesses make geniuses out of ordinary managers. If you find a highly profitable business that can convert sales into increased income, you are on your way to discovering a winning investment.
Sean Hannon, CFA, CFP is a professional fund manager.