Which profit measure is most useful?
By
Deputy Editor
Tim Bennett Aug 21, 2009
Print this article
What's the best way to measure profit?
Profit is the key to share price growth and dividends. But how do you measure it? Take Royal Bank of Scotland's (RBS) latest results. For the half year to 30 June, 'statutory' operating profit (ie, following accounting rules) was £7.8bn. But after 'impairments' you get a loss of £244m. Further down the profit and loss account, you find a 'loss attributable to ordinary shareholders' of more than £1bn. Most firms report all these different profit figures, plus a few more. So what should you be watching out for?
Gross profit
For most sectors except financial services (which presents accounts slightly differently), this is a vital figure. For a retailer such as Morrisons, it's the difference between sales revenue less direct costs (costs that vary with sales, such as buying in stock). If sales are £300m and 'cost of goods sold' are £200m, then gross profit is £100m – giving a 33% gross margin. A sudden drop may mean prices are being slashed or supplier costs have risen sharply – both spell trouble.
Operating profit
This takes overheads (indirect costs that don't tend to vary with sales levels, such as salaries, rent and utilities) from gross profit. A decent margin means a business makes good money before funding costs (interest paid to banks and dividend payouts). But how worried should you be if it drops? It depends. Say a watchmaker sells 100 watches for £10,000, each at a margin of 50%, giving operating profit of £0.5m. A clothing retailer might sell 1,000,000 T-shirts for £10 on a margin of 5% – that's also £0.5m operating profit. Say the operating margin for both falls by three percentage points. Profits at the watchmaker fall to £470,000. But the clothing retailer's operating profits fall to £200,000 (1,000,000 x £10 x 0.02). So operating margins are particularly important in high volume, low margin areas such as clothing and food.
Beware exceptional items
Directors argue that shareholders should not fret about one-off, unusual hits to profit. So accounting rules allow bad news (reorganisation costs, falls in the value of long-term assets, or losses from selling them) to come in below operating profit. Thus operating profit is in effect 'profit before bad stuff'. But watch out. Many firms (telecoms, for example) restructure all the time just to survive, so there's nothing 'exceptional' about it. As for 'exceptional' asset write-downs – how many of us could borrow £100,000, spend it on a property that then falls in value, then tell the bank to ignore it as a 'one-off' error? So you must use your own judgement as to whether an 'exceptional' really is a one-off or not.
Ebitda
This is earnings before interest, tax, depreciation and amortisation. The last two reflect the wearing out of long-term, or fixed, assets. Analysts like Ebitda – stripping out subjective costs makes for a more reliable profit figure. But Ebitda also flatters directors. Before the credit crunch, telecoms firms, for example, could borrow (meaning high interest charges) to invest in new network capacity (meaning high depreciation charges), knowing that Ebitda, to which executive remuneration was often linked, ignored both. Many grew their companies rapidly using debt, and are now taking big 'exceptional' hits as acquisitions turn sour.
Retained profits
Once a company has knocked all costs off sales, you get 'retained' profit – what's left over as a buffer for future years. This matters because, subject to accounting tweaks, a firm can pay out cumulative past profits as dividends. So always check the payout ratio – what proportion of this year's profit before dividends has been paid out. Too high and payouts may not be maintained. Next, check total retained earnings at the foot of the balance sheet – the bigger this is, as a multiple of the latest (or last three years' averaged) dividend, the better.
FTSE 'dogs' mauled by the bear
Investors seeking income, a decent capital gain and an easy life are often tempted by 'dogs' strategies. These involve picking shares with high dividend yields (one year's dividend divided by the current share price) because a high yield points to a low share price. This in turn, say fans, is the way to bag an underrated company that should subsequently do well.
So how is the strategy doing now? The Daily Mail's Midas runs a portfolio of the ten highest-yielding shares in the FTSE 100. Every three months it's reviewed, with low-yielding stocks replaced by higher yielding ones. It's a nice strategy, and from 2001-2007, an investment of £10,000 would have more than doubled to £20,000. By comparison, the FTSE 100 rose 17% over the same period.
But how times have changed. Had you started using the same strategy in May 2007, your dogs would have turned £10,000 into £4,578 today, compared with £7,255 for the same invested in a FTSE 100 tracker. Worse still, your dividend income would have been battered as companies have slashed payouts to save cash.
The lesson is that although high yields can point to cheap shares in a bull market (2001 to 2007), they can also be a bribe for taking the risk of investing as firms struggle with a downturn. With Capita Registrars forecasting that UK firms may slash dividends by a further 15% in 2009 with "little sign of any improvement next year", the strategy is best avoided for now.
• This article was originally published in MoneyWeek magazine issue number 449 and was available exclusively to magazine subscribers. To ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now
and get your first three issues free.
Published in
How to invest
| More
articles
by
Tim Bennett
Related articles
-
By Jody Clarke, Nov 20, 2009
-
By Merryn Somerset Webb, Nov 17, 2009
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.
