Investing for Beginners Net Profit Margin A companys net profit margin tells you how much after-tax profit the business makes for every $1 it generates in revenue or sales. Profit margins vary by industry, but all else being equal, the higher a companys net profit margin compared to its competitors, the better. There are some notable exceptions, but that would require getting into a complex analysis of something called the DuPont Return on Equity formula, which is beyond the scope of this lesson. The short and sweet version: It is possible for a business to make more absolute net profit by focusing on lowering its net profit margin and driving sales through the roof as customers are attracted to its stores. Wal-Mart is a perfect example of this approach, as it has a much lower net profit margin (3% to 4%) compared to a retailer such as Dillard (7% to 8%), the regional mall department store, yet Wal-Mart earns almost 34x the total net profit because it sells exponentially more goods. There is a danger in this approach, especially when dealing with high-end brands. Lowering prices to drive sales is often called going downstream. Once a retailer has lost status in the mind of the public, the business can begin to suffer. This is the reason you have never seen, nor are you ever likely to see, a single sale or discount at Tiffany & Company. How to Calculate the Net Profit Margin To calculate net profit margin, several financial books, sites, and resources tell an investor to take the after-tax net profit divided by sales. While this is standard and generally accepted, some analysts prefer to add minority interest back into the equation, to give an idea of how much money the company made before paying out to minority owners (often, these are people who still hold a substantial stake of 20% or less; e.g., a successful family that sold 80% of its business to Berkshire Hathaway, yet retained the remaining stock as a private holding). Either way is acceptable, although you must be consistent in your calculations. You want all companies must be compared on the same basis. Option 1: Net Income After Taxes ÷ Revenue = Net Profit Margin Option 2: (Net Income + Minority Interest + Tax-Adjusted Interest) ÷ Revenue Again, it is important to reiterate that, in some cases, lower net profit margins represent a pricing strategy and are not a failure on part of management. Some businesses, especially retailers, some discount hotels, or some chain restaurants, may be known for their low-cost, high-volume approach. In other cases, a low net profit margin may represent a price war which is lowering profits, as was the case with the computer industry way back in the year 2000. Net Profit Margin Example In 2009, Donna Manufacturing sold 100,000 widgets for $5 each, with a cost of goods sold of $2 each. It had $150,000 in operating expenses, and paid $52,500 in income taxes. What is the net profit margin? First, we need to find the revenue or total sales. If Donnas sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue. The companys cost of goods sold was $2 per widget; 100,000 widgets at $2 each is equal to $200,000 in costs. This leaves a gross profit of $300,000 ($500k revenue - $200k cost of goods sold). Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes. Subtracting the tax bill of $52,500, we are left with a net profit of $97,500. Plugging this information into our formula, we get: $97,500 net profit ÷ $500,000 revenue = 0.195 net profit margin The answer, 0.195 [or 19.5%], is the net profit margin. Keep in mind, when you perform this calculation on an actual income statement, you will already have all of the variables calculated for you. Your only job is to put them into the formula. (Why then did I make you go to all the work? I just wanted to make sure youve retained everything weve talked about thus far!) Cherry Pie: Basic vs. Diluted Earnings per Share When you analyze a company, you have to do it on two levels, the “whole company” and the “per share”. If you decide ABC, Inc. is worth $5 billion as a whole, you should be able to break it down by simply dividing the $5 billion price tag by the number of shares outstanding. Unfortunately, it isn’t always that simple. Think of each business you analyze as a cherry pie and each share of stock as a piece of that pie. All of the company’s assets, liabilities, and profits are represented by the pie as a whole. ABC’s pie is worth $5 billion. If the baker (management) slices the pie into 5 pieces, each piece would be worth $1 billion ($5 billion pie divided into 5 pieces = $1 billion per slice). Obviously, any intelligent connoisseur of pastries would want to keep the baker from making too many slices so his or her piece was as big as possible. Likewise, an ambitious investor hungry for returns is going to want to keep the company from increasing the number of shares outstanding. Every new share management issues decreases the investor’s “piece” of the assets and profits a tiny bit. Over time, this can make a huge difference in how much the investor gets to eat (in this case, take out in the form of cash dividends). “How can management increase the number of shares outstanding?” you ask. There are four big knives (perhaps “cleavers” would be a more appropriate term) in any management’s drawer that can be used to increase the number of shares outstanding: •stock options, •warrants, •convertible preferred stock, and •secondary equity offerings All four of these sound more complicated than they are. Stock options are a form of compensation that management often gives to executives, managers, and in some cases, regular employees. These options give the holder the right to buy a certain number of shares by a specific date at a specific price. If the shares are “exercised” the company issues new stock. Likewise, the other three cleavers have the same potential result – the possibility of increasing the number of shares outstanding. This situation leaves Wall Street with the problem of how much to report for the earnings per share figure. In response, the accountants created two sets of EPS numbers: Basic EPS and Diluted EPS. The basic EPS figure is the total earnings per share based on the number of shares outstanding at the time. The diluted EPS figure reveals the earnings per-share a business would have generated if all stock options, warrants, convertibles, and other potential sources of dilution that were currently exercisable were invoked and the additional shares printed resulting in an increase in the total shares outstanding. The percentage of a company that is represented by these possible share dilutions is called “hang”. Although ABC may have 5 shares outstanding today, it may actually have the potential for 15 shares outstanding during the next year. Valuation on a per-share basis should reflect the potential dilution to each share. Although it is unlikely all of the potential shares will be issued (the stock market may fall, meaning a lot of executives won’t exercise the stock options, for example), it is important that you value the business assuming all possible dilution that can take place will take place. This practiced conservatism can mean the difference between mediocre and spectacular returns on your investment. At the bottom of the page is an excerpt from Intel’s 2001 income statement. In 2000, the difference between Intel’s basic and diluted EPS amounted to around $0.06. If you consider the company has over 6.5 billion shares outstanding, you realize that dilution is taking more than $390 million in value from current investors and giving it to management and employees. That is a huge amount of money. Finding Hidden Potential Share Dilution According to accounting rules, companies dont include the possible share dilution from options that are underwater. This occurs when an employee owns options to buy shares at a certain price, and due to a sudden drop in stock market value, the option is below the exercise price. If, and this is a big if, the stock does not rise over the exercise price, the option will expire worthless. On the other hand, if the stock advances to higher levels, these options will probably be exercised, increasing the number of shares outstanding, and dilution your percentage ownership in the business. From a mathematical standpoint, it makes sense not to exclude the underwater options in the diluted earnings per share figure because they would be anti-dilutive. That is, the price that the option holder paid would exceed the market value of the stock resulting in the company collecting more money than the shares were worth on the stock exchange. For the investor, you need to keep the level of underwater options in mind as you look at a potential investment because most options have extended lives, sometimes as long as 10 years. In that time, it is very likely if not certain that some of those options will become valuable once the companys stock price rises. Thus, a company with a lot of underwater potential dilution could look cheap on paper but as the stock rises, find itself treading water for years as a result of an ever-increasing total of shares outstanding. An Example of Underwater Options Im going to take one of my favorite investments, Abercrombie & Fitch. Both I and companies in which I have major investments have traded in the common stock and derivatives based upon the firm. Im also going to reach nearly a decade into the past to illustrate my point instead of using current data and making you believe I have an opinion about a particular company one way or the other. According to Abercrombies past 10K filings with the Securities and Exchange Commission, Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options exercise prices were greater than the average market price of the underlying shares. As you analyze companies, you must keep your eye out for unusually large potential dilution. Anything more than 2% or 3% of shares should raise your eyebrows. Share Repurchase Programs and Stock Buy Backs Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Below is a reprint of an article I published several years ago that talks about how share repurchases, stock buybacks, and stock repurchases can increase your wealth if they are managed wisely. Stock Buybacks - The Golden Egg of Shareholder Value Overall growth is not nearly as important as growth per share… All investors have no doubt heard of corporations authorizing share buyback programs. Even if you dont know what they are or how they work, you at least understand that they are a good thing (in most situations). Here are three important truths about these programs - and most importantly, how they make your portfolio grow. Principle 1: Overall Growth is not nearly as important as Growth per Share Too often, youll hear leading financial publications and broadcasts talking about the overall growth rate of a company. While this number is very important in the long run, it is not the all-important factor in deciding how fast your equity in the company will grow. Growth in the diluted earnings per share is. A simplified example may help. Lets look at a fictional company: Eggshell Candies, Inc. $50 per share 100,000 shares outstanding ------------------------------------------- Market Capitalization: $5,000,000 This year, the company made a profit of $1 million dollars. ================================== In this example, each share equals .001% of ownership in the company. [100% divided by 100,000 shares.] Management is upset by the companys performance because it sold the exact same amount of candy this year as it did last year. That means the growth rate is 0%! The executives want to do something to make the shareholders money because of the disappointing performance this year, so one of them suggests a stock buyback program. The others immediately agree. The company will use the $1 million profit it made this year to buy stock in itself. The very next day, the CEO goes and takes the $1 million dollars out of the bank and buys 20,000 shares of stock in his company. (Remember it is trading at $50 a share according to the information above.) Immediately, he takes them to the Board of Directors, and they vote to destroy those shares so that they no longer exist. This means that now there are only 80,000 shares of Eggshell Candies in existence instead of the original 100,000. What does that mean to you? Well, each share you own no longer represents .001% of the company... it represents .00125%. Thats a 25% increase in value per share! The next day you wake up and discover that your stock in Eggshell is now worth $62.50 per share instead of $50. Even though the company didnt grow this year, you still made a twenty five percent increase on your investment. This leads to the second principle. Principle 2: When a company reduces the amount of shares outstanding, each of your shares becomes more valuable and represents a greater percentage of equity in the business. If a shareholder-friendly management such as this one is kept in place, it is possible that someday there may only be 5 shares of the company, each worth one million dollars. When putting together your portfolio, you should seek out businesses that engage in these sort of pro-shareholder practices and hold on to them as long as the fundamentals remain sound. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 over the past few years. That is long term value! Principle 3: Stock Buybacks are not good if the company pays too much for its own stock! Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually harmful if a company pays more for its stock than it is worth or uses money it cannot afford to spend. In an overpriced market, it would be foolish for management to purchase equity at all, even in itself. Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market moves the other way and is trading below its true value, shares of the company can be bought back up at a discount, giving shareholders maximum benefit. Remember, even the best investment in the world isnt a good investment if you pay too much for it. Return on Equity - ROE One of the most important profitability metrics is return on equity (or ROE for short). Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. Its what the shareholders own. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners. Why Return on Equity Is Important A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a companys return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth (shareholders equity) of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity ($5 ÷ $100 = .05, or 5%). The higher you can get the return on your equity, in this case 5%, the better. Formula for Return on Equity The formula for Return on Equity is: Net Profit ÷ Average Shareholder Equity for Period = Return on Equity Return on Equity Example Take a look at the same financial statements Ive provided from Martha Stewart Living Omnimedia at the bottom of the page. Now that we have the income statement and balance sheet in front of us, our only job is to plug a the numbers into our equation. The earnings for 2001 were $21,906,000 (because the amounts are in thousands, take the figure shown, in this case $21,906, and multiply by 1,000. Almost all publicly traded companies short-hand their financial statements in thousands or millions to save space). The average shareholder equity for the period is $209,154,000 ([$222,192,000 + 196,116,000] ÷ 2]). Lets plug the numbers into the formula. $21,906,000 earnings ÷ $209,154,000 average shareholder equity for period = 0.1047 return on equity, or 10.47% This 10.47% is the return that management is earning on shareholder equity. Is this good? For most of the twentieth century, the S&P 500, a measure of the biggest and best public companies in America, averaged ROEs of 10% to 15%. In the 1990s, the average return on equity was in excess of 20%. Obviously, these twenty-plus percent figures probably wont endure forever. In the past few years alone, small and large corporations alike have issued repeated earnings revisions, warning investors they will not meet analysts quarterly and / or annual estimates. Return on equity is particularly important because it can help you cut through the garbage spieled out by most CEOs in their annual reports about, achieving record earnings. Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report record earnings because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out as cash dividends. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of managements fiscal adeptness than the annual earnings per share. Variations in the Return on Equity Calculation The return on equity calculation can be as detailed as you desire. Most financial sites and resources calculate return on common equity by taking the income available to the common stock holders for the most recent twelve months and dividing it by the average shareholder equity for the most recent five quarters. Some analysts will actually annualize the recent quarter by simply taking the current income and multiplying it by four. The theory is that this will equal the annual income of the business. In many cases, this can lead to disastrous and grossly incorrect results. Take a retail store such as Lord & Taylor or American Eagle, for example. In some cases, fifty-percent or more of the stores income and revenue is generated in the fourth quarter during the traditional Christmas shopping period. An investor should be exceedingly cautious not to annualize the earnings for seasonal businesses. If you want to really understand the depths of return on equity, you need to open a new browser, leave this lesson in the background, and go read Return on Equity - The DuPont Model. This article will explain the three things that drive ROE and how you can focus on each one to increase your business or determine how safe growth is in another company; you could, for instance, figure out if recent improvements in profits were due to rising debt levels instead of better performance by management. Calculating Asset Turnover The asset turnover ratio calculates the total revenue for every dollar of assets a company owns. To calculate asset turnover, take the total revenue and divide it by the average assets for the period studied. (Note: you should know how to do this. In lesson 3 we took the average inventory and receivables for certain equations. The process is the same. Take the beginning assets and average them with the ending assets. If XYZ had $1 in assets in 2000 and $10 in assets in 2001, the average asset value for the period is $5 because $1+$10 divided by 2 = $5.) A quick exercise would benefit your understanding. Asset Turnover = Total Revenue ÷ Average Assets for Period In 2001 and 2000, Alcoa (Aluminum Company of America) had $28,355,000,000 and $31,691,000,000 in assets respectively, meaning there were average assets of $30,023,000,000 ($28.355 billion + $31.691 billion divided by 2 = $30.023 billion). In 2001, the company generated revenue of $22,859,000,000. When applied to the asset turnover formula, we find that Alcoa had a turn rate of .76138. That tells you that for every $1 in assets Alcoa owned during 2001, it sold $.76 worth of goods and services. $22,859,000,000 revenue ÷ $30,023,000,000 average assets for period = .76138, or $0.76 for every $1 in revenue General Rules for Calculating Asset Turnover There are several general rules that should be kept in mind when calculating asset turnover. First, asset turnover is meant to measure a companys efficiency in using its assets. The higher the number, the better, although investors must be sure compare a business to its industry. It is fallacy to compare completely unrelated businesses as different industries have different customs, economics, characteristics, market forces, and needs. The turnover for a local corner grocery store is going to be magnitudes quicker than the turnover for a manufacturer of space engine components or heavy construction equipment. Second, the higher a companys asset turnover, the lower its profit margins tend to be (and visa versa). This is because many businesses adopt a low-margin, high-volume approach that can result in rapid growth and economies of scale. As weve previously discussed in many other articles, Wal-Mart is the quintessential example of this tactic. Third, there may be special situations in which management purposely lowers asset turnover because it believes that a companys products are undervalued or there are other factors at play in the market that lead executives to think selling is disadvantageous at the time so they honor past sales contracts while stockpiling incoming production. A silver mine suffering from depressed silver prices may decide not to pre-sell so much of its output, instead locking it away in a vault and then turning around to halt production if the extraction cost exceed the sale value of each Troy ounce. This does not indicate that management is doing something wrong, though it would create a blip on the financial statements. In the long-run, the discipline they are showing may very well result in a lot more wealth being put in the owners collective pockets. This is one of the big reasons you cannot just look at the asset turnover ratio trajectory and come to any hard and fast conclusions; you must understand the reason behind the direction it is going and whether or not you believe it to be justifiable by the facts and conditions in place at the time. Return on Assets and Why It Is Important to the Investor Where asset turnover tells an investor the total sales for each $1 of assets, return on assets, or ROA for short, tells an investor how much profit a company generated for each $1 in assets. The return on assets figure is also a sure-fire way to gauge the asset intensity of a business. Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light (in the case of a software companies, once a program has been developed, employees simply copy it to a five-cent disk, throw an instruction manual in the box, and mail it out to stores). Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal (the shareholders’ capital plus short and long-term borrowed funds). Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, the return on assets and return on equity figures will be the same. There are two acceptable ways to calculate return on assets. Option 1: Net Profit Margin x Asset Turnover = Return on Assets Option 2: Net Income ÷ Average Assets for the Period = Return on Assets Return on Assets as a Measure of Asset Intensity (or How Good a Business Is) The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies). The first option requires that we calculate net profit margin and asset turnover. In most of your analyses, you will have already calculated these figures by the time you get around to return on assets. For illustrative purposes, we’ll go through the entire process using Johnson Controls as our sample business. Our first step is to calculate the net profit margin. We divide $469,500,000 (the net income) by the total revenue of $18,427,200,000. We come up with 0.025 (or 2.5%). We now need to calculate asset turnover. We average the $9,911,500,000 total assets from 2001 and $9,428,000,000 total assets from 2000 together and come up with $9,669,750,000 average assets for the one-year period we are studying. Divide the total revenue of $18,427,200,000 by the average assets of $9,660,750,000. The answer, 1.90, is the total number of asset turns. We have both of the components of the equation to calculate return on assets: .025 (net profit margin) x 1.90 (asset turn) = 0.0475, or 4.75% return on assets The second option for calculating ROA is much shorter. Simply take the net income of $469,500,000 divided by the average assets for the period of $9,660,750,000. You should come out with 0.04859, or 4.85%. [Note: You may wonder why the ROA is different depending on which of the two equations you used. The first, longer option came out to 4.75%, while the second was 4.85%. The difference is due to the imprecision of our calculation; we truncated the decimal places. For example, we came up with asset turns of 1.90 when in reality, the asset turns were 1.905654231. If you opt to use the first example, it is good practice to carry out the decimal as far as possible. Is a 4.75% ROA good for Johnson Controls? A little research shows that the average ROA for Johnson’s industry is 1.5%. It appears Johnson’s management is doing a much better job than the competitors. This should be welcome news to investors.
Posted on: Fri, 08 Aug 2014 23:05:00 +0000
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