Gross Profit
The gross profit is the total revenue subtracted by the cost of generating that revenue. In other words, gross profit is sales minus cost of goods sold. It tells you how much money a business would have made if it didn’t pay any other expenses such as salary, income taxes, office supplies, electricity, water, rent, etc.

When you look at an income statement, GAAP rules require that gross profit be broken out and clearly labeled as its own line so you can’t miss it. Still, you should know how to calculate it for yourself so here is the formula:

Total Revenue – Cost of Goods Sold (COGS) = Gross Profit

The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss in a moment. In fact, you can’t really look at gross profit on its own and know if it is “good” or “bad”, making the gross margin even that much more important.

An Example of Gross Profit from One of My Companies
To help illustrate the concept of gross profit, I’ll give you an example from one of the businesses in which I have a substantial ownership stake. The company is called Kennon Home Accessories. It sells a lot of luxury shaving sets both online and through its flagship retail store just north of Kansas City. If a customer purchases an imported British luxury shaving set for $315, our cost of goods sold would typically be $160 for the set itself, $20 for various merchant fees, service charges, and bank processing costs, and $20 for shipping and handling into our retail store.

This results in revenue of $315 – cost of goods sold of roughly $200 for a gross profit of $115 per every shaving set sold. If we were to drop the price 20% for a sale, the calculation would change to $252 revenue – $200 costs of goods sold = $52 gross profit. The $115 in the first case, or the $52 in the second, is the money we have available to pay our sales associates, taxes, office supply expense, and computer costs. The higher the gross profit, the more money we have for expansion, salaries, or dividends to shareholders.

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To calculate gross profit margin, use this formula: Gross Profit ÷ Total Revenue

Calculating Sample Gross Profit Margin
For illustration purposes, let’s calculate the gross profit margin of Greenwich Golf Supply (a fictional company) using its income statement. You will find the statement at the bottom of this page in Table GGS-1.

Assume the average golf supply company has a gross margin of 30%. (You can find this sort of industry-wide information in various financial publications, online finance sites such as moneycentral.com, or rating agencies such as Standard and Poors).

We can take the numbers from Greenwich Golf Supply’s income statement and plug them into our formula:

$162,084 gross profit ÷ $405,209 total revenue = 0.40

The answer, .40 (or 40%), tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.

Gross Profit Margin Over Time
The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud or accounting irregularities. If you are analyzing the income statement of a business and gross margin has historically averaged around 3%-4%, and suddenly it shoots upwards of 25%, you should be seriously concerned. For more information on warning signs of accounting fraud, I recommend Howard Schilit’s Financial Shenanigans: 2nd edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports.

Debt can increase a company’s return on equity, but too much can take a company into bankruptcy. The key is to calculate something known as the debt to equity ratio, which tells you how much debt a company has for every $1 in net worth.

The amount of long term debt on a company’s balance sheet is crucial. It refers to money the company owes that it doesn’t expect to pay off in the next year. Long term debt consists of things such as mortgages on corporate buildings and / or land, as well as business loans.

A great sign of prosperity is when a balance sheet shows the amount of long term debt has been decreasing for one or more years. When debt shrinks and cash increases, the balance sheet is said to be “improving”. When it’s the other way around, it is said to be “deteriorating”. Companies with too much long term debt will find themselves overwhelmed with interest payments, a risk of having too little working capital, and ultimately, bankruptcy. Thankfully, there is a financial tool that can tell you if a business has borrowed too much money.

Debt to Equity Ratio
The debt to equity ratio measures how much money a company should safely be able to borrow over long periods of time. It does this by comparing the company’s total debt (including short term and long term obligations) and dividing it by the amount of shareholder equity. (We haven’t covered shareholder equity yet, but we will later. For now, you only need to know that the number can be found at the bottom of the balance sheet. You’ll actually calculate the debt to equity ratio in segment two when we look at real balance sheets.

The result you get after dividing debt by equity is the percentage of the company that is indebted (or “leveraged”). The normal level of debt to equity has changed over time, and depends on both economic factors and society’s general feeling towards credit. Generally, any company that has a debt to equity ratio of over 40% to 50% should be looked at more carefully to make sure there are no liquidity problems. If you find the company’s working capital, and current ratio / quick ratios drastically low, this is is a sign of serious financial weakness.

Profitable Borrowing
If a business can earn a higher rate of return than the interest rate at which it borrows, it becomes profitable for the business to borrow money. (An example: If a corporation earned 15% on its investments and borrowed funds at 8%, it would make 7% on the borrowed money [15% return - 8% cost of money = 7% net profit]. This boosts what analysts call “Return on Equity”. We will talk about Return on Equity, or ROE, in a future lesson. It is briefly touched on in the Retained Earnings section of this lesson.)

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The current ratio is a financial ratio designed to tell you the level of current assets compared to current liabilities. The current ratio that is “good” for a company depends upon its industry.

The current ratio is another test of a company’s financial strength. It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during the same year. You can find the current ratio by dividing the total current assets by the total current liabilities. For example, if a company has $10 million in current assets and $5 million in current liabilities, the current ratio would be 2 (10/5 = 2).

An acceptable current ratio varies by industry. Generally speaking, the more liquid the current assets, the smaller the current ratio can be without cause for concern. For most industrial companies, 1.5 is an acceptable current ratio. As the number approaches or falls below 1 (which means the company has a negative working capital), you will need to take a close look at the business and make sure there are no liquidity issues. Companies that have ratios around or below 1 should only be those which have inventories that can immediately be converted into cash. If this is not the case and a company’s number is low, you should be seriously concerned.

Inefficiency
If you’re analyzing a balance sheet and find a company has a current ratio of 3 or 4, you may want to be concerned. A number this high means that management has so much cash on hand, they may be doing a poor job of investing it. This is one of the reasons it is important to read the annual report, 10K and 10Q of a company. Most of the time, the executives will discuss their plans in these reports. If you notice a large pile of cash building up and the debt has not increased at the same rate (meaning the money is not borrowed), you may want to try to find out what is going on.

Microsoft has a current ratio in excess of 4, a massive number compared to what it requires for its daily operations. The company has no long term debt on the balance sheet. What are they planning on doing? No one knew until the company paid its first dividend in history, bought back billions of dollars worth of shares, and made strategic acquisitions.

Although not ideal, too much cash on hand is the kind of problem a smart investor prays for.
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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 company’s 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. The higher a company’s asset turnover, the lower its profit margin tends to be (and visa versa).

Next page > Return on Assets … > Page <<back, 30, 31, 32, 33, 34, 35, 36, more >>

This page is part of Investing Lesson 4 – How to Read an Income Statement. To go back to the beginning, see the Table of Contents.

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For that reason, according to CFO Magazine, a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of financial analysis in 1919. That system is used around the world today and will serve as the basis of our examination of components that make up return on equity.

Composition of Return on Equity using the DuPont Model

There are three components in the calculation of return on equity using the traditional DuPont model; the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, we can discover the sources of a company’s return on equity and compare it to its competitors.

Net Profit Margin

The net profit margin is simply the after-tax profit a company generated for each dollar of revenue. Net profit margins vary across industries, making it important to compare a potential investment against its competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales. This low-cost, high-volume approach has turned companies such as Wal-Mart and Nebraska Furniture Mart into veritable behemoths.

There are two ways to calculate net profit margin (for more information and examples of each, see Analyzing an Income Statement):

1. Net Income ÷ Revenue
2. Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue.

Whichever equation you choose, think of the net profit margin as a safety cushion; the lower the margin, the less room for error. A business with 1% margins has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning.

Asset Turnover

The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:

• Asset Turnover = Revenue ÷ Assets

The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.

Equity Multiplier

It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:

• Equity Multiplier = Assets ÷ Shareholders’ Equity.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)

• Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).

Pepsico

To help you see the numbers in action, I’ll walk you through the calculation of return on equity using figures from Pesico’s 2004 annual report. The key figures I’ve taken from the financial statements are (in millions):

• Revenue: $29,261
• Net Income: $4,212
• Assets: $27,987
• Shareholders’ Equity: $13,572

Plug these numbers into the financial ratio formulas to get our components:

Net Profit Margin: Net Income ($4,212) ÷ Revenue ($29,261) = 0.1439, or 14.39%
Asset Turnover: Revenue ($29,261) ÷ Assets ($27,987) = 1.0455
Equity Multiplier: Assets ($27,987) ÷ Shareholders’ Equity ($13,572) = 2.0621

Finally, we multiply the three components together to calculate the return on equity:

Return on Equity: (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%

Analyzing Your Results

A 31.02% return on equity is good in any industry. Yet, if you were to leave out the equity multiplier to see how much Pepsico would earn if it were completely debt-free, you will see that the ROE drops to 15.04%. In other words, for fiscal year 2004, 15.04% of the return on equity was due to profit margins and sales, while 15.96% was due to returns earned on the debt at work in the business. If you found a company at a comparable valuation with the same return on equity yet a higher percentage arose from internally-generated sales, it would be more attractive. Compare Pepsico to Coca-Cola on this basis, for example, and it becomes clear (especially after adjusted for stock options) that Coke is the stronger brand.

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What is Enterprise Value?

Enterprise value is a figure that, in theory, represents the entire cost of a company if someone were to acquire it. Enterprise value is a more accurate estimate of takeover cost than market capitalization because it takes includes a number of important factors such as preferred stock, debt, and cash reserves that are excluded from the latter metric.

How is Enterprise Value Calculated?

Enterprise value is calculated by adding a corporation’s market capitalization, preferred stock, and outstanding debt together and then subtracting out the cash and cash equivalents found on the balance sheet. (In other words, enterprise value is what it would cost you to buy every single share of a company’s common stock, preferred stock, and outstanding debt. The reason the cash is subtracted is simple: once you have acquired complete ownership of the company, the cash becomes yours). Let’s examine each of these components individually, as well as the reasons they are included in the calculation of enterprise value:

Market Capitalization: Frequently called “market cap”, market capitalization is calculated by taking the number of outstanding shares of common stock multiplied by the current price-per-share. If, for example, Billy Bob’s Tire Company had 1 million shares of stock outstanding and the current stock price was $50 per share, the company’s market capitalization would be $50 million (1 million shares x $50 per share = $50 million market cap).

Preferred Stock: Although it is technically equity, preferred stock can actually act as either equity or debt, depending upon the nature of the individual issue. A preferred issue that must be redeemed at a certain date at a certain price is, for all intents and purposes, debt. In other cases, preferred stock may have the right to receive a fixed dividend plus share in a portion of the profits (this type is known as “participating”). Regardless, the existence represents a claim on the business that must be factored into enterprise value.

Debt: Once you’ve acquired a business, you’ve also acquired its debt. If you purchased all of the outstanding shares of a chain of ice cream stores for $10 million (the market capitalization), yet the business had $5 million in debt, you would actually have expended $15 million; $10 million may have come out of your pocket today, but you are now responsible for repaying the $5 million debt out of the cash flow of the business – cash flow that otherwise could have gone to other things.

Cash and Cash Equivalents: Once you’ve purchased a business, you own the cash that is sitting in the bank. After acquiring complete ownership, you can simply take this cash and put it in your pocket, replacing some of the money you expended to buy the business. In effect, it serves to reduce your acquisition price; for that reason, it is subtracted from the other components when calculating enterprise value.

Why Is Enterprise Value Important?

Some investors, particularly those that follow a value philosophy, will look for companies that are generating a lot of cash flow in relation to enterprise value. Businesses that tend to fall into this category are more likely to require little additional reinvestment; instead, the owners can take the profit out of the business and spend it or put it into other investments.

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One of the limitations of the p/e ratio is that it doesn’t factor in growth in underlying earnings. Back when Sam Walton was rolling Wal-Mart stores throughout the United States, his customers could have told you that the cookie-cutter formula was going to continue to be rolled out throughout the nation. The gains in annual profit from year-to-year were eye-popping. The result? An astronomical p/e ratio. Still, when factoring in future growth, Wal-Mart was one of the cheapest stocks available on a value basis because the future cash flows more than justified that level of valuation – after all $10,000 invested back during the IPO with dividends reinvested is now worth north of $10,000,000 and throws off at least $170,000 in cash dividends each year.

The PEG Ratio to the Rescue

There is a way to adjust for the shortcomings of the p/e ratio and it’s called the PEG ratio. It stands for the price-to-earnings-to-growth ratio. To calculate the PEG ratio simply take the p/e ratio and divide the growth in earnings per share.

Imagine that we have two companies – Company ABC and Company XYZ. The first, Company ABC, trades at $20 per share and has $1.50 in per share earnings with conservatively estimated future growth of 3% per annum. The second, Company XYZ, trades at $60 per share, has $4 in per share earnings and has conservatively estimated future growth of 5% per annum. Which stock is the cheaper one?

Using the PEG ratio we can answer that question. We would simply plug in the numbers to the PEG ratio formula and get the following:

Company ABC: $20 per share divided by $1.50 = 13.33 p/e ratio divided by 3% growth = 4.443 Company XYZ: $60 per share divided by $4.00 = 15.00 p/e ratio divided by 5% growth = 3.000

In this case, Company XYZ appears cheaper at $60 per share than Company ABC does at $20 per share despite having a higher p/e ratio as a result of the future growth in earnings. The guideline to use is that the lower the PEG ratio, the cheaper the stock.

Optimism is Your Enemy When Using the PEG Ratio

The biggest danger in the PEG ratio is approach is that humans are naturally optimistic. By banking too much on the promise of the future, a stock that would otherwise be worthless might appear to be a great bargain. This is what you had in the days of the dot-com bubble. Everyone was convinced that each new Internet business that went public would become the next Microsoft or Cisco. The difference: Both of those companies had very real earnings, and very real earnings growth. There were rumors years ago that Warren Buffett was once reviewing projections for future growth at Blockbuster. After looking at the figures, he mentioned that if you thought rationally about the assumed growth rate, every man, woman, and child would need to rent two videos per day, 365 days per year to make those estimates come to fruition. That isn’t going to happen. You need to frame your growth assumptions in this same way – ask yourself the underlying implications. This mental discipline can protect you from the downside of the PEG ratio, while still letting you take advantage of its basic premise.

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Those financial ratios that show the percentage of a company’s capital structure that is made up on debt or liabilities owed to external parties

Liquidity Financial Ratios

Those financial ratios that show the solvency of a company based on its assets versus its liabilities. In other words, it lets you know the resources available for a firm to use in order to pay its bills, keep the lights on, and pay the staff.

Operating Financial Ratios

These financial ratios show the efficiency of management and a company’s operations in utilizing its capital. In the retail industry, this would include metrics such as inventory turnover, accounts receivable turnover, etc.

Profitability Financial Ratios

These financial ratios measure the return earned on a company’s capital and the financial cushion relative to each dollar of sales. A firm that has high gross profit margins, for instance, is going to be much harder to put out of business when the economy turns down than one that has razor-thin margins. Likewise, a company with high returns on capital, even with smaller margins, is going to have a better chance of survival because it is so much more profitable relative to the shareholders’ contributed investment.

Solvency Financial Ratios

These financial ratios tell you the chances of a company going bankrupt. There’s really no elegant way to say that. The whole point of calculating them is to make sure that a company isn’t in danger of going under anytime soon.

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The Difference Between Cash Flow and Earnings
To understand why the price to cash flow ratio matters, you have to understand some accounting. The profit and loss statement (or income statement as it is more commonly known) does not always equal the cash flow statement. It’s theoretically possible for a company to report huge profits and be unable to pay its bills due to liquidity problems. (In fact, I remember one chain store that reported high earnings but didn’t have enough cash on hand to pay its operating leases and was forced into bankruptcy.)

Imagine you own a bakery. You have $100,000 in cash to start your business from an inheritance. You buy equipment worth $80,000, leaving $20,000 in cash for working capital. You expect the equipment to last for 10 years and have no value when it’s reached the end of that period.

Immediately, the balance sheet would show $80,000 in property, plant & equipment – cost, $20,000 in cash and nothing else. At the end of the year, if you had no sales, your income statement would show $0 in revenue, $8,000 in depreciation expense ($80,000 cost – $0 salvage value divided by 10 years = $8,000 annual depreciation) for a pre-tax operating loss of $8,000.

Thus, the balance sheet at the end of year one will be $20,000 cash, $80,000 property plant & equipment – cost (offset by $8,000 in accumulated depreciation so that the balance sheet shows a net depreciation balance of $72,000) and retained earnings of -$8,000. Each year, you would write off an additional $8,000 until the value of the equipment on the balance sheet had been reduced to $0.

The reality of the situation is much different. You aren’t losing $8,000 per year. Instead, in the first year, you spent $80,000. You only have $20,000 in the bank. The result is that you actually have $8,000 more in cash each year than the profit and loss statement would indicate. Once you began to generate profit, the price to earnings ratio would understate the amount of money you had available in subsequent years to put to work in expansion, whereas the price to cash flow ratio would more accurately describe the situation. That’s not to say that the depreciation expense isn’t real – it certainly is, as Warren Buffett reminds us that the tooth fairy doesn’t pay for capital expenditures!

The Price to Cash Flow Ratio is Better for Some Industries
The accounting rules sometimes cause certain types of businesses or industries to understate or overstate their true profits, causing the price to cash flow ratio to work better for valuation purposes than its counterpart, the price to earnings ratio. Take a pharmaceutical company, which is required to expense massive amounts of research and development when it is developing drugs. One could make a compelling argument that those expenses should not be taken all at once, but instead spread out of the period when a drug is sold because it is equivalent to buying equipment for your bakery. Yet, the current rules require that much of the cost be written off as an expense when it is incurred, meaning that early years in a product development tend to show very low profits, or in some cases even massive losses, with inflated profits toward the end.

When examining a potential investment, this is no small matter. The price to earnings ratio of a drug company is going to be less useful than the price to cash flow ratio as a result of these accounting rules. That’s why you often hear Wall Street analysts talking about the life cycle of drug patents. They make adjustments for drugs that have been in development, drugs that will soon be subject to generic competition, and other factors so that they can estimate the funds available to stockholders during any given fiscal year.

Thus, the price to earnings ratio is simply not useful in such as scenario. The price to cash flow ratio would provide a better idea of the amount of money available to management for further research and development, marketing support, debt reductions, dividends, share repurchases, and more. For the best results, a good analyst would most likely average several years, perhaps as much as one full business cycle, of cash flow statements to get an adjusted price to cash flow ratio that factored in the entire development cycle of several drugs or products.

Calculating the Price to Cash Flow Ratio
The price to cash flow ratio is calculated by taking the current share price and dividing the total cash flow from operations found on the cash flow statement. Some investors prefer to use a modified price to cash flow ratio based on something known as free cash flow. It adjusts for expenses such as amortization and depreciation, changes in working capital, and capital expenditures. In fact, in my own businesses I would never consider using anything other than the free cash flow formula because it more accurately indicates the underlying economic condition of a business or asset.

Using the Price to Cash Flow Ratio to Value Stocks
The average price to cash flow ratio varies from industry to industry. For companies involved in capital intensive activities, such as the auto companies and railroads, you are going to see much lower price to cash flow multiples because investors know that much of the money is going to have to be poured back into equipment, facilities, materials, and fixed assets or else the firm will be hurt. Imagine, for instance, if a car company stopped updating its factories – at some point, the cars simply can’t be made!

Industries such as software, on the other hand, allow for much higher price to cash flow ratios because they have very low capital requirements. Once the product has been developed, the only real cost is a cheap piece of plastic (the DVD or CD) to put the program on and the cardboard for the box.

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