Is Profitability Important When Picking Stocks?

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Most people have a handful of key metrics or company traits they emphasize when selecting stocks. For example, you might look at its P/E ratio as a gauge of how expensive it is compared to similar companies, or simply make your picks based on your perceived longevity of the brand.

So how does profitability, a metric many entrepreneurs value above all else, measure up? Is it a good idea to pick stocks based on company profitability? While we tend to think of profitability as a positive trait, the answer may not be so black and white.

Revenue vs. Profitability

Let’s start by defining exactly what profitability is, and the best way to do that is to compare it to a similar, yet distinct metric: revenue. Revenue is the total dollar value of the income generated by a company’s operations. If you’re running a movie theater, for example, revenue would be all the money spent on movies, snacks, and lobby entertainment. Profit, on the other hand, is the amount of that income remaining once you account for expenses, debts, and operating costs. It’s sometimes referred to as net income.

It’s important to recognize there are many different types of revenue and profit to consider, but these basic definitions will be enough to help you master them conceptually. Companies often use resource planning software to track their profitability, and may use accounting strategies to recognize profits or losses in different quarters.

Ultimately, a lack of both profitability and revenue is a sure sign that a company is doing poorly. Conversely, high revenue and high profitability is also a good sign. Where we get into ambiguous territory is when there’s a mismatch between revenue and profitability—but even these scenarios can tell you much about a company’s health, and viability as a stock pick.

High Revenue, Low Profitability

Let’s imagine a company with high revenue, but low profitability. This usually means the company is taking its income and is reinvesting in new assets, new locations, new products, and other features designed to support it in the future. This doesn’t represent all cases, but is a fair generalization for the bulk of companies in this category.

There are a few advantages here:

  • Growth potential. Companies that are constantly investing in themselves have explosive growth potential. They tend to generate more sales, faster than their contemporaries, which makes them top picks for growth investors.
  • Future focus. These companies are also highly future-focused. They’re willing to take a loss in the short term if it means maximizing their long-term potential, which makes them excellent picks for long-term investors.
  • Proof of concept. The high revenue portion of the equation demonstrates a significant level of customer interest. It’s a kind of proof-of-concept that’s an indication of company value. If the company isn’t making a profit now, it could likely readjust to make more of a profit in the future.

Low Revenue, High Profitability

A company with low revenue and high profitability, on the other hand, is operating at peak efficiency, and is not interested in growing much further. They may prioritize value to shareholders, or may be content at their current size and scope.

Either way, there are some advantages:

  • Dividends. Because these companies focus on (and relish in) profit, they typically pay higher-than-average dividends, and consistently, too. For dividend investors, these are ideal companies.
  • Stability. Because they have the model figured out, these companies are typically more stable than their competitors. The high profit levels give them a bigger cushion of cash to work with, and more wiggle room to deal with future challenges. This makes them solid long-term buys in many cases.
  • Management strength. Maintaining high profitability means working hard to keep costs down while maximizing customer interest. It’s often a sign of good management and leadership, accordingly.

Company Goals and Vision

One of the biggest variables in this equation is the company’s goals and visions. In many cases, the actual numbers don’t matter as much as the numbers a company is trying to hit (which is why earnings reports are so important). For example, if a company knows it’s going to take a loss in a given quarter, with revenue remaining high, it’s a sign the company has a plan for the future. If a company expects record profits, but barely breaks even, it’s a sign of mismanagement. Pay close attention to a company’s mission, the knowledge of its leadership, and how it responds to the numbers (in addition to the numbers themselves).

Considering Your Personal Goals

Ultimately, revenue and profit should play into your strategy in a way that suits whatever type of trader you are. If you’re interested in stable, dividend-paying corporations, something with high profitability may be favorable, while if you’re more interested in long-term growth potential and profiting in the distant future, high-revenue, low-profit models may be better. Neither of these metrics are surefire ways to gauge the strength of a prospective investment, but in the right hands, and with the right analysis, they can help make almost any stock pick better.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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