How to Use Profitability Ratios in Investment Banking - dummies

How to Use Profitability Ratios in Investment Banking

By Matt Krantz, Robert R. Johnson

Beginners in investment banking commonly refer to a company as having “high margins.” That kind of clichéd talk may sound impressive in a locker room, but it sounds quite naïve in a boardroom.

As more experienced investment banking professionals know, the term profit margin doesn’t really mean much. Profit margin is a catchall term that describes a number of financial ratios that are designed to help put a company’s profitability into perspective. The key ways to measure margins include gross margin, income from continuing operations margin and net margin.

Ratios to measure a company’s profitability stem from the same financial document: the income statement. The income statement is a powerful financial statement that lists all the company’s main forms of income and expenses. Investment bankers can glean many insights just by scanning this document.

But the income statement gets even more interesting after its data is applied to ratios. Financial ratios just put different parts of the income statement into perspective to provide additional insights not seen by looking at absolute numbers.

There are countless ways for investment bankers to slice and dice the financial statements, and there are countless financial ratios.

Why gross margin isn’t so gross after all

If you knew a company turned a gross profit of $3 billion, that piece of information by itself wouldn’t tell you much. Gross profit is what’s left of revenue after paying direct costs. But $3 billion in isolation isn’t very telling. Enter gross margin. Gross margin is a relatively simple calculation that tells investment bankers a great deal about the business.

A company’s gross margin is gross profit divided by total revenue. The product tells you how much of every $1 in revenue the company keeps after paying direct costs. In essence, this is the money that’s left and can be used to pay overhead and provide a return to shareholders.

Investment bankers can use gross margin as a way to see how profitable a company is before the distortion of overhead costs, which are often more controllable than direct costs. Like most ratios, though, the gross margin number itself is most meaningful in comparison with other companies and other industries.

Income from continuing operations

A company’s gross margin may tell you how a company is doing managing its revenue and raw materials costs, but there’s much more to running a business profitably.

Investment bankers pay attention to income from continuing operations margin as a way to see what proportion of revenue the company is able to hang onto after paying all its costs, including overhead, before the distortion of interest expenses and other peripheral costs. The ratio disregards unusual or one-time items that don’t have anything to do with the ongoing functioning of the business, such as asset sales or restructuring charges.

Income from continuing operations margin is calculated as follows:

Income from Continuing Operations Margin = (Total Revenue − Cost of Revenue − Operating Expenses + Net Interest Expense + Unusual Items − Income Tax Expense) ÷ Total Revenue

The result will be a percentage that tells you how much of every dollar the company keeps from revenue after paying all the ongoing costs of doing business.

Profits with net margin

Net income isn’t perfect. After all, net income is a financial measure created by accountants for everyone, not a tool designed for investment banking professionals. Even so, and despite the criticism mounted on net income, it’s still a basis of accounting that all companies must follow. The uniformity of net income makes it a valuable tool, if anything, to compare disparate companies with each other.

Another beauty of net margin, despite its shortcomings, is that it’s easy to calculate. Net income is provided by companies on their income statements. Calculating net margin is just a matter of:

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This calculation of net margin gives you a percentage that tells you how much of every dollar a company earns after paying all its expenses, at least following the sometimes convoluted rules of accountants.

Net margin is another example of a profitability margin that can vary wildly depending on the industry the company is in. Investment bankers must take the time to carefully compare a company’s net margin with peers before drawing significant conclusions from it. You can get a good feel for how net margins can vary by industry.

Industry Net Margin (Five-Year Average)
Energy 12.7%
Technology 11.8%
Healthcare 11.4%
Industrials 9.7%

Source: Thomson-Reuters