Saturday, December 3, 2011

Profitability of Companies and Stock Investments

If you want to find profitable investments you have to analyse a lot securities and annual reports, also watch news on business portals as Bloomberg or others. But reading business news will not bring successful investment results without additional effort.

The first thing you have to understand about stocks and other investments is profitability. Profitability of stock is a results of gambling, if you want to measure real profitability, you have to focus on profitability ratios of companies.

Why profitability ratios are important? It is natural question, and you have to know that everything is important but anything cannot be interpreted without a context. The single profitability ratio will not provide for you all the necessary information. Because different profitability ratio will show you different information. There are two main kinds of company's profitability: profitability based on assets or equity (balance sheet ratios) or profitability based on some kind of profit (income statement ratios). Both directions are important but shows different things to us. At first you have to know that there are many types of profit: gross profit, EBITDA, EBIT, pretax profit, net profit, profit after minority, attributable to to shareholder or any other. All of these profits may show for you some profitability.

But now let's concentrate on the main ratios that are used in investment market by investment professionals. The mostly used ratios for profitability measurement are profit margin, EBITDA margin, ROA (return on assets)  and ROE (return on equity).
Profitability margins and company's EBITDA margins are the margins that based on ratios from income statement when ROE and ROA ratios are complex when data are used from income statement and balance sheet. All those ratios might be important.

The more company is profitable the better is for shareholder but in other hand when profitability is very high, there is no much potential left. If investor wants to invest in a stock that would have a lot of potential in the future he should look for companies that have low profitability. In that case the investor could expect for profitability to grow in future. That would give some potential for price increase. But profitability do not changes without any reason, there must be some conditions for turnaround of the company. If investor is sure about such conditions then maybe he should choose such companies for investment, but such investing in kind a risky one. Especially risky are investments in unprofitable companies with expectation for turnaround.