Investment Banking: Pros and Cons of Return on Equity versus Other Profitability Measures - dummies

Investment Banking: Pros and Cons of Return on Equity versus Other Profitability Measures

By Matt Krantz, Robert R. Johnson

Return on equity isn’t the only profitability measure that investment banking analysts pay attention to, although it is arguably the most important one. Several other measures deserve consideration, as well.

You probably know Coca-Cola is a ubiquitous brand around the world. In fact, none other than Warren Buffett himself has indicated he thinks that it’s the best brand in the world. A measure of the strength of Coke’s brand is that there are Coca-Cola stores online, in New York City, and in Las Vegas. When people will pay you to advertise their brand, you know you have a strong franchise.

Here are abbreviated financial statements (income statement and balance sheet) from the Coca-Cola Company for the years 2010, 2011, and 2012.

Abbreviated Income Statement 2012 2011 2010
Sales 48,017 46,542 35,119
Cost of Goods Sold (19,053) (18,215) (12,693)
Gross Profit 28,964 28.327 22,426
Selling, General, and Administrative Expenses (18,185) (18,154) (14,013)
Earnings Before Interest and Taxes 10,779 10,173 8,413
Interest Income 471 483 317
Interest Expense (397) (417) (733)
Equity Income 819 690 1025
Other Income 137 529 5185
Earnings Before Taxes 11,809 11,458 14,207
Taxes 2,723 2,812 2,370
Net Income 9,086 8,648 11,837
Abbreviated Balance Sheet 2012 2011 2010
Current Assets 30,328 25,497 21,579
Long-Term Assets 55,846 54,477 51,342
Total Assets 86,174 79,974 72,921
Current Liabilities 27,821 24,283 18,508
Long-Term Debt 14,736 13,656 14,041
Other Liabilities 10,449 10.114 9,055
Total Equity 33,168 31,921 31,317
Total Liabilities and Equity 86,174 79,974 72,921

Source: EDGAR

The other profitability measures that investment bankers consider are gross profit margin, operating profit margin, and net profit margin.

Gross profit margin

Gross profit equals sales minus the cost of goods sold. Coca-Cola’s gross profit margin for 2012 is computed as follows:

This profitability measure shows the basic cost structure of the firm and, like many calculated measures, is very industry specific. The beverage industry is characterized by very wide margins. The actual cost to produce and bottle the product is fairly low. The real significant costs come in advertising and building the brand.

Over the last three years, Coca-Cola has been able to maintain a fairly stable gross profit margin — the margins were 60.9 percent and 63.9 percent in years 2011 and 2010, respectively.

It’s not enough to just eyeball one year’s gross profit margin and think that tells you much. One thing investment bankers would key their eye on with the Coca-Cola example is the fact that the trend in the ratio is down slightly. Further erosion in gross profit margin over the next couple years may be cause for concern.

Operating profit margin

Operating profit (also known as earnings before interest and taxes) is gross profit minus sales, general, and administrative expenses (SG&A). Coca-Cola’s operating profit margin for 2012 is computed as follows:

This profitability measure tells you what percentage of sales is left over after paying all costs prior to paying the suppliers of capital (stockholders and bondholders) and Uncle Sam (taxes). This gives the analyst an idea of what’s left (on a percentage basis) to pay taxes and the suppliers of capital. An eroding operating profit margin would be cause for concern.

Over the last three years, Coca-Cola has been able to maintain a very stable operating profit margin — the margins were 21.9 percent and 24.0 percent in years 2011 and 2010, respectively. This would indicate to the analyst that over the last three years, Coca-Cola has experienced very little business risk.

Net profit margin

Net profit margin is defined as bottom line net income (after taxes and interest expense have been paid) divided by sales. Coca-Cola’s net profit margin for 2012 is computed as follows:

Simply put, net profit margin measures how much of every dollar of sales the company is able to keep as earnings. Over the last three years, Coca-Cola has had very enviable net profit margins — the margins were 18.6 percent and 33.7 percent in 2011 and 2010, respectively.

Now, you may think that analysts would be concerned that net profit margin declined considerably from 2010 to 2011. However, when you dig deeper, you see that this was the result of a one-time, extraordinary gain from the acquisition of Coca-Cola Enterprises North American business operations. A net profit margin in the neighborhood of 19 percent is more consistent with the history of the company.