Wednesday, February 2, 2011

7 Faces of Profit

Its the time of the year when quarterly reports flood mailboxes and dailies, and the words 'earnings' and 'profit' jump out from all over. But which profit should you consider to evaluate a company ? What is the utility of profitability measures ? Here's a guide to understanding profits.

1. Gross Profit
It is the amount earned from sale of products after deducting production costs.
What it does:
Signals efficiency with which a company is making money. Indicates how much mark-up a company can generate on its sales. A company with rising gross profit means it can command premium prices, cost efficiency, and makes the company highly competitive.
Black spots:
Works as a primary indicator. G.P. is similar to an incomplete story. To know more about the company, you have to read other signs.

2. Ebitda
It means earnings(or profit) before interest, taxes, depreciation and amortization. Calculated by subtracting operating, general, administrative and marketing expenses from gross profit.
What it does:
Measures profitability. Say, you are having trouble deciding between companies, it is the best tool to compare them because it weeds out the effects of financing and accounting decisions.
Black spots:
It is not a good measure of cash flows. Companies may use it to dress up earnings.

3. Ebit
It is the earnings before interest and taxes. Calculated by deducting depreciation and amortization charges from Ebitda.
What it does:
Measures a company's earning capacity. Examines performance of companies by negating the effects of financing and taxes. Useful for shareholders and creditors.
Black spots:
Ignores unavoidable cash outflows due to interest and taxes.

4. EBT
It is the earnings (or profit) before taxes and is calculated by deducting interest expenses from Ebit.
What it does:
Compares companies in different tax jurisdictions. Useful for comparing companies within a sector. Shows how well a company is using its borrowings to enhance its return on equity.
Black spots:
Again, doesn't give a wholesome picture. Discounting the tax effect is unwise.

5. EAT
This is the Net Profit. Earnings after tax, or net profit, is the most common way to calculate a company's profit. EAT is the company's profit after deducting manufacturing and operating expenses, depreciation, interest and tax.
What is does:
Tells the story of a company's performance over a period. Handy tool for equity shareholders as it is the money left after a company makes all payments. EAT helps shareholders analyse the earnings of a company on a per-share basis. Equity dividends are also based on EAT.

6. EPS
Earnings per share is calculated by dividing net profit by the total number of shares.
What is does:
Considered the single-most important measure of a share's price. Shows how much a company is earning on every share. For example, if a company makes a post-tax profit of 12 lakh INR and there are 2 lakh shares in issue, the EPS would be 6 INR.
Black spots:
Ignores capital. Two companies can have the same EPS, but the second company may have used lesser capital employed. Other things being equal, the second is the better company as it is more efficient.

7. P/E Ratio
P/E = Current share price of a company divided by its earnings per share.Though not strictly a measure of profit, it is a favourite tool of analysts to measure a company's value. It tells if a share is overvalued or undervalued.
What it does:
Shows how much an investor is willing to pay for every rupee of a company's earnings. Analyst use a forward P/E ratio to fix target prices of companies. Generally, a high P/E means investors expect higher earnings growth in the future.

Black spots:
The PE, at best, a lagging indicator, which takes into account only the past earnings, not the future growth. As such, a low PE may give the impression that the stock is undervalued, but if the company's earnings are not growing, its value is also not likely to rise. Similarly, a high PE could make a stock's valuation seem stretched, but what if the company's earnings are likely to keep growing rapidly? In such cases, using the PE ratio would not be a good idea. 

8. PEG
Price to Earning Growth metric. It is essentially an enhanced version of the PE ratio, which combines value with growth. the PEG ratio is calculated by dividing the stock's PE ratio by its expected 12-month earnings growth rate. (PEG ratio = PE / earnings per share growth). 
What it does:
The premise for using this ratio is rooted in the understanding that the growth rate of a stock that is valued correctly would be almost equal to its PE ratio. In other words, The PEG ratio of a fairly valued stock would ideally be equal to one. When the PEG is equal to one, it means that the market has correctly factored in the expected earnings growth. A PEG ratio of less than one would mean that the market has not adequately priced in higher growth expectations and that the stock is, therefore, undervalued. A PEG ratio higher than one implies that the market is paying much more for the stock than is justified by its earnings growth. So, the lower the PEG of a stock, the better it is.
Black spots:
Its not foolproof indicator of value. Since it is a forward looking measure, one has to rely on analyst's projection of future earnings, which may not always be accurate.

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