Chapter 10 Profitability and Return on Investment Profitability

Chapter 10 Profitability and Return on Investment

Profitability and return on investment z Investments are made with a view to: yearnings ycapital appreciation z Investors will assess investment under: y 1. profitability y 2. return on investment y 3. payout policy z Ratios, etc. developed to assess these y. As with all FA, context is key when interpreting Chapter 10 © Philip O’Regan 2016 2

Profitability z Critical for long-term viability z Gross profit rate y(Gross Profit / Revenue) x 100% yfocus on trading activity z Operating profit rate y(Operating Profit / Revenue) x 100% z Net Profit rate y(Net Profit / Revenue) x 100% z Operating/net/EBIT/PBIT interchangeable! z EBIDTA Chapter 10 © Philip O’Regan 2016 3

Return on investment z Relationship between investment & earnings z Numerator (earnings) must be consistent with denominator (investment) z Return on Capital Employed (ROCE): y(EBIT / Capital Employed) x 100% y. Capital Employed usually long-term funding y. Denominator can also include short-term debt z Relationship between ROCE and other ratios y. ROCE = Operating Profit Rate x Asset Turnover Chapter 10 © Philip O’Regan 2016 4

Return on investment ctd. z Return on Equity (ROE) y. Focus on return enjoyed by owners y. I. e. denominator is Equity (Shareholders’ Funds) y. Numerator changes to reflect this, i. e. , profit after interest, tax and preference dividends z ROE = y. Profit after interest, tax and preference divs. x 100% Equity (Shareholders’ Funds) Chapter 10 © Philip O’Regan 2016 5

Earnings per share (EPS) z Widely used and closely regulated z EPS = Earnings / Equity shares in issue z Must be provided at end of income statement with workings in notes z IAS 33: basic and diluted EPS z Calculation of denominator complicated by: ynew issues yshare options Chapter 10 © Philip O’Regan 2016 6

Market ratios z Price/Earnings Ratio (PER or P/E Ratio) y. Relationship between earnings and market price y. Important benchmark – industry averages available y= market price per share / EPS z Earnings yield inverts this ratio y= EPS / market price per share y. Measures earnings generated in relation to market price z Widely used by investors: y. Higher PER = expectation of EPS growth z PEG = PER/Prospective growth in EPS y. Prospective growth based on assumptions Chapter 10 © Philip O’Regan 2016 7

Payouts z Investors invest to earn a return z Total Shareholder Return (TSR): y= Share price appreciation + Dividends z Increasingly companies also engaged in share buybacks y. Involves company acquiring own shares in market y. Benefits for both shareholder and company x. Occasionally used to favourably impact ratios y. Attractive to companies with cash surplus Chapter 10 © Philip O’Regan 2016 8

Dividend policy z Dividends: distribution of profit to shareholders z Company dividend policy can depend on: yprevious policy yavailability of profits and cash ymarket expectations z Dividend Yield y(Dividend per share/Market price per share) x 100% z Dividend Cover y. Profit after Tax less Pref Dividend / Ordinary Dividend z Dividend Payout y(Ord. Div. / Profit after Tax less Pref Div. ) x 100% Chapter 10 © Philip O’Regan 2016 9

Summary z Businesses must generate returns yprofits ycapital appreciation z Ratios developed to assess earnings/return yrelate earnings to investment being assessed z Profitability ratios assess success of firm in generating profits z Earnings ratios assess performance of firm from perspective of investors Chapter 10 © Philip O’Regan 2016 10