How do I measure a company's ability to make money?

Investing with moomoo joined discussion · Jul 9, 2021 12:04

By Melody
A company's most important goal is to make money and keep it. When a company no longer has the ability to keep making money, its share price will drop significantly.

Does this mean we can only buy into companies with positive net income?

NO.

$Tesla (TSLA.US)$would be a perfect example. Tesla was listed in 2009, but the company didn't break even till 2020. Not having a positive net income did not stop Tesla shares from skyrocketing. This is because the share price does not simply reflect a company's net income, but rather its profitability.

So how can I gain insight into how well a company generates and retains money?

Knowing how to calculate and analyze a corporate profit margin is a great way to gain insight into how well a company generates and retains money.

Understanding a company's margin ratios can be a starting point for further analysis to decide if a company would be a good investment option.

Analyzing corporate profit margins using profit-margin ratios

It's tempting to rely on net earnings alone to gauge profitability, but it doesn't always provide a clear picture of a company. (Again, look at Tesla.) Using it as the sole measure of profitability can be a bad idea.

Profit-margin ratios can give investors deeper insight into management efficiency.

There are three key profit-margin ratios:gross profit margins, operating profit margins, and net profit margins.

Gross profit margins

The gross profit margin tells us how much profit a company makes on its cost of sales, or cost of goods sold(COGS). In other words, it indicates how efficiently management uses labor and supplies in the production process. Here is the formula:

Gross Profit Margin = Gross Profit/Total Revenue*100%

Companies with high gross margins will have money left over to spend on other business operations, such as research and development or marketing. When analyzing corporate profit margins, look for downward trends in the gross margin rate over time. This is a telltale sign the company may have future problems with its bottom line.

While it might be a little complicated to calculate these ratios, moomoo makes it easy for moomooers by providing these ratios for us :D!

For PC users:

How do I measure a company's ability to make money?

For mobile users:

Operating profit margins

By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company's management has been at generating income from the operation of the business. This is the calculation:

Operating Profit Margin = EBIT/Sales

This ratio is a rough measure of the operating leverage a company can achieve in the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs.

Moomooers can get the EBIT and Sales numbers from the financial tab and simply divide them and the operating profit margin.

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For mobile users:

Net profit margins

Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible to summing up in a single figure how effectively the managers are running a business:

Net Profit Margin = Net Income/Total Revenue*100%

Just like gross and operating profit margins, net margins vary between industries. By comparing a company's gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance, and marketing costs.

This one is also shown directly on moomoo :D!

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For mobile users:

The bottom line

Margin analysis is a great tool to understand the profitability of companies. It tells us how effective management can wring profits from sales, and how much room a company has to withstand a downturn, fend off competition, and make mistakes. But, like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that is fed into them. Correct analysis also depends on a consideration of the company's industry and its position in the business cycle.

Margin ratios highlight companies that are worth further examination. Knowing that a company has a gross margin of 25% or a net profit margin of 5% tells us very little. As with any ratio used on its own, margins tell us a lot, but not the whole story, about a company's prospects.

Source: Investopedia

Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only. Read more