Investing Fundamentals: Profitabiltiy and Margins [Part 3]

Your guide to understanding profitabiltiy and how to incorpoarte it into investment research.

Introduction

The ultimate goal of most companies is to earn a profit for its shareholders or owners. While a company may not be profitable year after year there needs to a history or profits or at the very least a reasonable likelihood for a company to become profitable in the future before you should consider it as a possible investment opportunity.

There are however exceptions to this rule where companies may be unprofitable but still present an investment opportunity if they trade below their liquidation value. Cases like these are however extremely rarely and difficult to find in todays market. 

Profit is a key leading indicator of what a share price may do in the future. Over the long term a share price tends to follow the earnings of a company. A company with a profit that is growing year after year is likely to see a rise in share price over the same period. On the other hand, a company that starts to become unprofitable and incurs losses will typically see a decline in share price.

What is profit?

Simply put profit is what is left from revenue or income after deducting expense items. In small unlisted entities the profit of a business will go the owners of the business. In a large publicly traded company, the profit belongs to the shareholders of the entity. Companies can distribute profits back to shareholders in the form of dividends. A company however has no obligation to pay dividends to shareholders. A company can instead use profit to reinvest back into the business by making acquisitions, purchasing new equipment or hiring additional staff.

Types of Profit

On a typical income statement, you will see three different types of profit. These are gross profit, operating profit and net profit. Each type of profit paints a slightly different picture as to the health and profitability of a business.

Gross Profit

Gross Profit = Revenue Cost of Goods Sold

Gross Profit Margin (%) = Gross Profit / Revenue 

Gross profit is the first type of profit listed on an income statement and is the most straight forward to understand. A businesses gross profit is simply the revenue minus the cost of goods sold. For example if you sell boerie rolls outside the rugby stadium for R20, and each boerie roll cost you R12 to make, you will make a gross profit of R8 for each boerie roll you sell.

Gross profit can also be expressed as a percentage of revenue. When this is done, it is referred to as a gross profit margin. Using the same example as above, each boerie roll will be sold at a gross profit margin of 40%. This is calculated by taking the gross profit of R8 and dividing by the revenue of R20 to derive a margin of 40% (8/20 = 0,4).

When it comes to profit margins, much like other areas of life, bigger is better. It however important to make a fair comparison when comparing profit margins. Different industries will attract different profit margins due to the nature of the goods sold or the service provided. A grocery retailer like Shoprite will have a much lower gross profit margin then a software company like Microsoft. This is because a company like Shoprite will purchase goods directly from a wholesaler and then charge a small markup when selling the goods. Whereas a software company like Microsoft that develops their own software products can charge a much higher markup than what the software cost then to produce. Shoprite for the most recent financial year had a gross profit margin of 24.5% compared to Microsofts gross profit margin of 68.70% for the most recent financial period.

Operating Profit

Operating Profit = Gross Profit Other Operating Costs

Operating Profit Margin (%) = Operating Profit / Revenue

Operating profit is the next type of profit you will see on the income statement. This is the profit a company earns from its core business operations for a given period excluding interest and taxes. A companys operating profit is simply the gross profit less any other operating costs that are not included in the cost of goods sold. Other operating costs are often referred to as selling, general and administrative costs and include rent, payroll, insurance, deprecation, repairs and maintenance and other overheads.

Net Profit

Net Profit = Operating Profit Interest Expense Tax Expense + Interest Income + Dividends

Net Profit Margin (%) = Net Profit / Revenue

Net profit is the final profit figure you will see on the income statement and is referred to as the bottom line. Net profit takes at look at what is remaining from revenue after taking into account all business expenses both from core operations and non-core operations. Net profit differs from operating profit in that it takes into account interest and taxes but also takes into account non-operating income like interest income and dividends received. To calculate your net profit, you take the operating profit and subtract your interest expense and tax expense and add any interest income and dividends received.

How to apply this to your investment research

Now that we have covered the basics of the three types of profit margins it is important to understand how to build this knowledge into your framework for researching stocks.

The first thing I like to do when looking at an income statement is looking directly at the gross profit, operating profit and net profit figures to see whether they are all positive and that the business is not in a loss-making position. Once I am satisfied that the business is profitable, I will then calculate the profit margins. As mentioned above the profit margin is simply the profit line divide by revenue.

We typically expect our gross profit margin to be the largest followed by the operating profit and then lastly the net profit margin. Once Ive calculated the profit margins, I like to see what the net profit margin is. If the net profit is very low this could indicate that the company has a higher a likelihood of becoming unprofitable should there be a negative change in the business. I usually like to see a minimum net profit margin of 5% before researching further. Anything less than 5% means that any unfavorable change like rising costs or a drop in revenue due to consumer spending decreasing could mean that the business may become unprofitable. The higher the net profit margin the more room for the error the business has to remain profitable.

My next step would be to take a look at the historical profit figures. I usually take the most recent 5 financial periods worth of data. If the company is relatively new company, there may not be 5 years worth of data to compare so in this case it might be better to use quarterly data if available. I typically use MorningStar or Tikr to get historical financial data. However, you could also use companys financial statements directly from there website as an alternative. This approach however is slightly more cumbersome.

Once I have my historical data set, I will then assess whether profit has grown over the past 5 years. If the figure in year 5 (the most recent financial year) is greater than the figure in year 1, I consider this a tick. You can also calculate a compounded annual growth rate (CAGR) for the profit lines to determine how quickly the business is growing its profits. This can be done with the following formula:

Profit CAGR = [(Year 5 profit Year 1 profit) / Year 1 profit] / 5

Here is a practical example of this calculation:

Historical Gross Profit Figures:

2021: R200

2020: R180

2019: R140

2018: R120

2017: R110

Gross Profit CAGR = [ ( 200 110 ) / 110 ] / 5

                                 = [ 90 / 110 ] / 5

                                 = 0.82 / 5

                                 = 16.36%

Thus, based on the above figures our hypothetical company has grown its gross profit at a compounded rate of 16.36% per year. If there share price growth has been lagging the profit growth this may present an investment opportunity.

After Ive looked at the profit growth, I will assess the historical profit margins using my 5-year data set. If the profit margins are declining this could be an indicator of higher supplier costs, lower selling prices or increased competition in the industry. Consistently declining profit margins are a big red flag and may indicate that a business is losing its competitive advantage. The opposite is also true. Where profit margins are increasing this may be a sign that a business is becoming more efficient and is able to either sell their products at a higher price to an increased demand or is able to lower costs due to economies of scale.

The final exercise before making an investment decision is to compare the profit margins to similar companies in the same industry. For example, if you are deciding whether or not to invest in Shoprite an important exercise would be to compare the gross profit, operating profit and net profit margins of Shoprite to competitors in the same industry, such as Woolworths and Pick and Pay to see how Shoprite stacks up. If Shoprite has stronger profit margins than its competitors, then there is a good likelihood that they offer a more favourable and safer investment opportunity than the competitors.

Conclusion

Investing in a business with a consistent history of profitability and strong profit margins relative to its competitors is crucial to investment success and avoiding unnecessary losses. Profitability should however not be your only consideration when making an investment decision but should form an integral part of your investing research framework. It is also important to consider other factors like balance sheet health.