Max(Reward) Control

 

 At the end of the day, we are interested in measuring the probability of gaining max(Reward) from an investment. In doing so, we calculate Return on Investment (ROI) as follows [1,3]:

ROI=[(Net Return)/Cost]*100%= (Capital Gains)-Commission+(Dividend Yield)

and

Annualized ROI = [(1+ROI)**(1/n)-1]*100%,

where n is the number of investment years.  

It is clear that the negative values ROI<0 mean that total costs are greater than returns (red score), whereas positive values ROI>0 indicate that net returns are positive because total returns are greater than any associated costs (green/amber). Even though ROI is a direct measure of profitability, it does not adjust for risk.

Both ROI and Return On Equity (ROE) are popular measures of financial performance and profitability [1]. While ROI is total profit divided by your initial investment,  ROE, on the other hand, measures how much profit a company generates when compared to its shareholders' equity.  Because shareholders' equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. The ROE formula is

ROE = 100% * (Annual Net Income)/(Average Shareholder’s Equity),

where net income is a company's income after deducting expenses (a company's annual net income is reported on its income statement) and shareholder's equity is the claim shareholders have on a company's assets, after its debts are paid (shareholder's equity is reported on the balance sheet). Here is the real-life example of ROE from www.businessinsider.com: according to FB’s most recent SEC filings, its net income in 2020 was about $29.15 B, total stockholder’s equity was $128.29 B, and so

ROE(FB)= $29.15 B / $128.29 B = 0.227 x 100 = 22.7%

That means that its annual net income is about 22.7% of its shareholders' equity. You can now look very carefully at how FB was performing compared to its peers and the outcome it's delivering.  

The above two ratios are not operational metrics. To compare business efficiency, you should look at the simplest bang-for-the-buck ratio such as Return on Assets (ROA)[1]

ROA = (Net Income)/(Total Assets)

As you can see, ROA is calculated by dividing a company’s net income by total assets. For example, if a company's ROA is 5%, this means the company earns 5 cents per $1 in assets. Higher ROA indicates more asset efficiency. ROAs over 5% are generally considered acceptable (Amber) and over 20% excellent (Green). For the sake of apple-to-apple comparison, ROAs should always be compared amongst firms in the same sector. A software maker, for instance, will have far fewer assets on the balance sheet than a car maker. As an investor, you can begin by comparing a company's ROA % from one year to another and looking for trends or changes. Doing this can help you determine whether a company is likely to have potential issues in the future (this is also a part of product de-risking).  

The EBITDA Margin is another useful performance metric related to a company's profitability from operations [47]

EBITDA Margin = EBITDA / Revenue,

Revenue = Net Sales

and

EBITDA = Operating Income (EBIT) + Depreciation + Amortization

It measures how much in earnings a company is generating before interest, taxes, depreciation, and amortization, as a percentage of revenue. EBITDA stands for earnings before interest, taxes, depreciation, and amortization [1]. Quarterly earnings press releases often cite EBITDA. The earnings are calculated by taking sales revenue and deducting operating expenses, such as the cost of goods sold (COGS), selling, general, & administrative expenses (SG&A), but excluding depreciation and amortization. For example, Company A has an EBITDA of $800,000 while their total revenue is $8,000,000. The EBITDA margin is 10%. Company B has an EBITDA of $960,000 and total revenue of $12,000,000. This means that while Company B demonstrates higher EBITDA, it actually has a smaller margin than Company A (8% against 10%). Therefore, an investor will see more potential in Company A [1].  

The above financial metrics are often complementary to the most common profitability ratios: Gross Profit, Net Profit, Operating Margin and Net/Gross Profit Margin [48]. The gross profit is the surplus or difference between the net sales and the cost of goods sold:

Gross Profit = Revenue(Sales) − Cost of Goods Sold

The gross profit margin is the percentage of the profits over the revenue.

Gross Profit Margin = 100%*(Revenue/Sales − Cost of Goods Sold) / Revenue(Sales)  

For example, a gross profit margin ratio of 65% is considered to be healthy.

The net profit often refers to the “bottom line”. It is the net income that is derived from subtracting the net sales from total costs including taxes

 

Net Profit = Net sales - Total Costs = Revenue – (COGS + Operating Costs+Interest+Tax),

The net profit margin refers to how much profit your business has generated as a percentage of your total revenue: 

 Net Profit Margin = (Net Profit / Revenue) x 100%

As a general rule of thumb, a 10% net profit margin is considered average, a 20% margin is considered good, and a 5% margin is low.

The operating margin is a measure that shows the percentage of operating income to the company's revenues. Operating margin provides a glimpse of how much a company makes on every dollar it earns:

Operating Margin = Operating Income / Net Sales

Higher operating margins are generally better than lower operating margins, so it might be fair to state that the only good operating margin is one that is positive and increasing over time. For example, GOOG produced an operating margin of 31.3% in 2021, the company's highest since early 2012.