Understanding company fundamentals – Profitability

Profit is an economic concept which occurs when the income from an economic transaction exceed the costs of carrying it out. For example, if a company sells windows that cost £500 in material and, plus £100 in labour and transportation costs, but they receive £1000 from the sale of the window, then their profit is £400 for each window sale. This profit will then be taxed at a certain rate, but what is left over is retained within the company to be spent as the directors see fit.

This, in a nutshell, is profitability. But why, then, are there different ‘types’ of profit recorded on income statements? The three represent profit at different stages of the income statement – for example, gross profit is the value of sales minus cost of goods or services sold.

After this, you have operating profit, which also extracts the costs of running the business. Finally, you have net profit, which also extracts the cost of interest repayments on company debt and taxes. To return to our initial example, the income statement might look something like the following;

Income £100,000
Cost of Materials £50,000
Gross Profit £50,000
Transportation Costs £4,000
Labour Costs £3,000
Office Costs £3,000
Operation Profit £40,000
Tax £7,600
Net Profit £32,600

Analysing profitability

At the most basic, I won’t consider investing in companies that don’t manage to consistently generate an annual profit over 5-10 years. Whilst all companies will undergo fluctuations in costs and income, a persistent inability to balance these to turn a profit is a clear indicator of poor management, an undesirable product and a failing company.

I also consider profitability as a percentage of turnover. In our example above, the company has a net profitability of 32.6%, which gives ample margin for temporary declines without causing a loss. When looking at profitability I prefer companies that are able to consistently grow their profitability, not just as a cash value, but as a percentage of turnover.

The larger companies get, the more I expect overheads to reduce as a percentage of costs and as a result, the great their profitability should become.  Successful investment opportunities are those which are able to drive down their costs and maximise their profits. Some businesses take the route of driving down quality with those costs, but in my opinion this is usually a failing strategy over the long-term as customers tend to move to other market providers as standards decline.

Of course, this idea that successful companies are always those which grow profitability isn’t always  true, and some companies face consistently slim margins that are prevalent throughout their industry. The prevalence and intensity of competitive market forces in some industries means that reducing costs or increasing prices is extremely difficult to do – the business might continue to be profitable, but the only way to grow those profits will be to increase turnover.

This makes it important to understand the wider context of the investment opportunity; the labour costs, market competitors and general operating principles of the business, rather than trying to make a blanket judgement based on generic ‘rules of thumb’. The increase in turnover can still lead to more cash profits, increased dividends and company value, and as a result, an appreciation in the share price, but it can also attract governance issues as the company struggles to maintain standards and culture across an increasingly diverse and wide-spread business.

It’s also useful to consider where revenue is coming from. In my simple example of a window company, the business only receives income from a single source – the sale of windows. The reality is that most companies will diversify their income streams across a number of economic activities. A window firm might also sell doors and roofing suppliers, provide an installation and repair service, and could diversify further across a range of ‘home improvement’ services.

In theory, this diversification is a good thing, but in practice, it’s important to consider whether these activities are profitable and deploy capital efficiently. For example, if the company’s capital is fully deployed in the sale of windows, producing a profit of 36.5%, but the sale of doors only produces a profit of 15%, then the company would be better off focusing on the sale of windows than doors as it is more than twice as profitable.

Of course, if the company only sells windows then it is open to the risk of new competitors arising that undercut its prices, attracting market share and causing revenues to fall, but this risk is reduced if there are multiple income streams.

Conclusion

Profitability is an important measure of a company’s attractiveness as an investment. It should be positive over the long-term i.e the company should not be losing money and it should be stable, If not growing as a percentage of revenue received.

It’s important to remember that profitability shouldn’t be viewed as a ‘stand-alone’ metric of financial health. Another key indicator is leverage, or how much debt a company has, which will be the topic of the next article in the Understanding Company Fundamentals series. We’ll look at different types of debt and what it can be used for, as well as how it affects the attractiveness of an opportunity.