Pitfalls of Profitability for Stock Picks (Part 1)
Profitability is an improvement over using absolute profits in isolation as reason to buy, hold, or sell stocks. Productivity is an essential part of any measure of business performance. However, even profitability has its limitations as a guide to stock investment decisions. Temporal gaps in profitability are the most glaring weaknesses in stock trading argumentation. Why should you back stocks with ‘flash-in-a-pan profitability, or with declines compared to past trends? A more threatening risk is that the profitability in the latest financial period, which entices you to take a stock decision, has poor chances of repetition in the near future. Similarly, projected profitability may be so distant on the horizon that it is not worth the discounted present value.
All time-related weaknesses of the profitability factor disappear once a trend covering five past and five future financial periods are used with the last actual results as a mid-point. We have a reasonable trend for factual stock analysis, and can ask relevant questions about assumptions and sensitivities. However, we are not yet past the choices of numerators and denominators. Profit after interest and taxes seems to be most appropriate if you are limited to domestic stocks, but net profit after tax and before interest is better if a federal bank keeps chopping and changing interest rates. Some investors look at taxation in great details, because a new management may plan for contributions to exchequers better. Many stock acquisition decisions are based on hidden values of improved tax planning.
Drawbacks of ROA, ROE, and ROIC for Stock Picks
The denominator is even more controversial than the upper figure of any profitability ratio. Return on equity (ROE) sounds right for an investor searching for new stocks, but what if a company is excessively leveraged? Were some of the executives who refinanced sub-prime loans in 2007, ROE aficionados? Return on Assets (ROA) is a distinct improvement on ROE. ROA over a period of time, and comparisons with competitors, as well as benchmarks from other sectors and countries, can speak volumes about investment attractions of specific stocks. The returns may be considered independent of taxation and interest, for additional perspectives of how stocks may fare under new management and regulatory frameworks. Return on Invested Capital (ROIC) goes a step forward compared to simple ROA, because it allows you to consider all the control parameters management teams have to work on stock value. Thus, ROIC analyses can yield invaluable clues about future hidden values of stocks.