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Most long-term investors instinctively want to invest in "good" companies that are profitable and hopefully growing. And academic factor models have often found that the stocks of profitable companies generally outperform other stocks over long periods of time. But there are different ways to analyze the profitability of a company. This article explains the two calculations that we are primarily using on StockMarketMBA.com to measure the profitability of U.S. companies: net income as a percentage of total sales and return on equity.
This is a really simple calculation that takes the company's net income as a percentage of total sales/revenue. The key is knowing what a "good number" is. Let's look at the trailing twelve months data for the stocks in the S&P 500 Index. We are showing this data by GICS sector because the profitability of each sector is quite different:
| GICS sector | Revenue | Net income | NI % |
|---|---|---|---|
| Total | 0 | 0 | 0.00% |
Keep in mind that the real estate sector includes real estate investment trusts, or "REITs", that don't pay tax at a corporate level, so the net income percentage for the real estate sector is higher because of that.
Let's also look at the trailing twelve months data for the stocks in the S&P Midcap 400 Index.
| GICS sector | Revenue | Net income | NI % |
|---|---|---|---|
| Total | 0 | 0 | 0.00% |
Return on equity is another approach to measure a company's profitability. It's a simple calculation: in our database, we take each company's trailing twelve months net income and divide that by total stockholder's equity per the company's most recent financial statements.
But the concept of what return on equity measures is more complex. Return on equity is affected by many factors. The biggest factor, of course, is how profitable the company is (i.e. net income is the numerator in the calculation). But return on equity measures profitability by factoring in how much capital (i.e. equity) you have to invest in order to generate that net income. Some businesses are inherently great businesses, where every dollar invested generates a massive return. Other businesses require a lot of capital, and don't generate as much return.
Apple and Microsoft, for example, are technology giants that operate businesses that print money. So of course they have a massive return on equity. Being a software giant is a very profitable business.
But to understand return of equity you need to look at examples of companies that are not software giants. Let's look at Invitation Homes, who owns and operates 80,000+ single family homes that it manages as rental properties, and Kroger Co, who owns grocery stores across the United States. Let's look at the key profitability stats for these two companies per our database using trailing twelve month ("TTM") data:
| Company | TTM Revenue | TTM NI % | Total Equity | ROE |
|---|---|---|---|---|
| Invitation Homes Inc | 0 | 0.00% | 0 | 0.00% |
| Kroger | 0 | 0.00% | 0 | 0.00% |
Invitation Homes has a net income percentage that is much higher than Kroger's, yet Invitation Homes has a much lower return on equity. Why is there such a difference? It's often difficult to determine if differences in return on equity are due to the actions of the company itself or due to the nature of the business/sector the company operates in.
Kroger has a lower net income as a percentage of sales but a much higher return on equity. It seems like that is mostly because Kroger has turned roughly the same amount of total stockholder's equity into total sales that are 100x that of Invitation Homes. But it is hard to reach conclusions. Is the grocery business a lower margin business than the business of owning rental real estate?
Invitation Homes makes money, and seems to be a nice business, but does the business of owning and running rental properties require a lot of capital? Is that why Invitation Homes has a low return on equity? Or has the management of Invitation Homes not taken enough steps to increase return on equity?
As shown above, a given company's profitability and/or return on equity might be largely determined by the business/sector that the company operates in. But company management can take steps to improve their return on equity.
Return on equity is affected by the company's use of leverage. Most large companies have quite a bit of debt outstanding, because they have either borrowed money from a bank or they have issued corporate bonds to investors. If the company successfully invests this borrowed money in it's core business, it's profits will go up, while the company's stockholder's equity remains the same, thereby increasing the company's return on equity.
Let's look at Kroger and Invitation Homes again. Here is a summary of their most recent balance sheets:
| Company | Date | Total assets | Total liabilities | Stockholders equity | Noncontrolling interests | Leverage factor |
|---|---|---|---|---|---|---|
| Invitation Homes Inc | 2022-03-31 | 18,544,222,000 | 8,319,090,000 | 10,182,856,000 | 42,276,000 | 1.82 |
| Kroger | 2022-02-28 | 49,086,000,000 | 39,657,000,000 | 9,452,000,000 | -23,000,000 | 5.19 |
Leverage factor is total assets divided by stockholders equity.
Kroger is a lot more leveraged than Invitation Homes. So the difficult question for Invitation Homes is whether they could borrow a lot more money to buy more single family homes, with the hope of improving their revenue and net income without requiring the use of that much more stockholders equity? Is that possible? Is that smart? There would be lots of challenges. Would their lenders agree to that? Does the company have the staff and/or the computer systems in place so that it can rapidly "scale up" to manage more single family rentals? What would happen if single family home prices tanked and Invitation Homes was highly leveraged (more so than today)? What would happen to Invitation Homes' stock price if they had a much greater return on equity? It is difficult for an investor to know the answer to such questions.
Return on equity is also affected by the company's dividend policies. When a company makes money, it can either reinvest the profits back into the business or it can payout a dividend to stockholders. If the company pays out a large portion of its income as dividends, the company's stockholder's equity is reduced (i.e. the amount of equity retained in the business is not as high). Assuming the company's core business can still generate the same profits that is has done before, the company's return on equity remain the same. Conversely, if the company keeps the profits, and doesn't pay out any dividends, the company's stockholder's equity goes up. That means that next year the company will need to generate even greater profits than before in order to keep the company's return on equity flat.
Return on equity is also affected by the company's stock repurchases. When a company repurchases it's own stock, the company's total stockholder's equity goes down. If the company's net income doesn't change as a result, the company's return on equity will go up.
Which measure of profitability is more useful? There is no right or wrong answer. In a perfect world, an investor would want to own the stock of a company that has both a high net income as a percentage of sales and a high return on equity. In other words, own Apple or Microsoft. But it is hard to say definitively that owning a profitable company like Invitation Homes that has a low return on equity is a bad investment.
All data is a live query from our database. The wording was last updated: 06/22/2020.
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