‘Profit’ is one of the most common words in the business cannon, but also one of the slippiest – meaning wildly different things to different people.
In simplest terms, profit – also known as earnings – is the difference between the revenue a company has generated in any given period and the costs it has incurred during that time.
But there’s much more to it than that.
Profitability is a vague term as there are myriad ways in which profit (or indeed losses) can be measured: Gross, Operating, Net, Pre-tax… the list goes on.
Reporting companies are often selective about the profit measure they opt to shine a light on; equally journalists are inconsistent on the figure they pay most attention to.
So when a company publishes results, you’ll often find the chief executive saying one thing, analysts another, and papers printing entirely conflicting stories – each publication sticking stubbornly to its own preferred measure of the p-word.
As an investor, therefore, it can be a nightmare trying to keep track of a company’s health. How can you be sure that the bottom line, really is the bottom line?
Companies reveal their revenue and profit in financial statements which often include some or all of the following profit measures.
This is the difference between a firm’s total revenue and the fundamental cost of the goods sold over a given period.
The cost of goods (COGS) excludes the other, often quite hefty, expenses related to making the sales – such as bills, wages and other overheads. So some City analysts disregard this measure as an unrealistic indicator of a firm’s health.
However, it is sometimes calculated as a percentage and called
Gross Margin is of particular interest to those operating in the retail sector, as shrinking margins can be a sign of heavy discounting or rising sourcing costs.
Conversely, if margins are growing, a company has a much better chance of covering its costs, making a good profit, generating cash and paying dividends.
As you might gather from the name, Operating Profit is calculated in the same way as Gross Profit, except it factors in the operating costs like rent and wages.
This is widely accepted as the most important profit tally in the majority of situations.
This is because the measure, which is also known as EBIT – earnings before interest and taxes – is generally felt to give a better overall picture of business health as it includes most of the costs directly related to making the sales.
This profit measure takes into account all of the above PLUS a business’s interest costs on any debts.
Then, if you include how much tax the business owes for the specified period, you get to another profit measure –
This is also known as , or sometimes , and is the number that is used to work out a company’s all-important figure. (Profit after tax divided by the number of shares a firm has in issue).
‘I would always pay more attention to Operating Profit (or EBIT) than I would to EPS,’ cautions AJ Bell investment director Russ Mould.
‘EPS can be manipulated in so many ways – tax planning and share buybacks to name but two – that it is not always a reliable indicator of performance.
‘There is nothing illegal in this, but you can find yourself being influenced by financial engineering and not the really important issue, which is how good is a company at what it does.’
This is the amount that a company has left after it has paid out dividends to its shareholders. These leftovers are often invested back into the business to help generate future profit growth.
The dividend itself can be a useful measure of company health too, of course.
‘An increase to the dividend usually signals management confidence in prospects, and year-on-year comparisons are also useful in establishing a direction of travel,’ explains Richard Hunter from Interactive Investor.
And just when you think we’re done, there’s EBITDA – earnings before interest and tax before depreciation and amortisation.
This figure excludes ‘underlying’ or ‘exceptional’ costs that a firm thinks it will incur as assets (such as a machine or a shop) wear out over time – the depreciation.
It is therefore a high level measure of whether a firm is earning at least some kind of operating profit before funding capital expenditure.
But EBIDTA (or is unpopular among many City analysts.
‘EBITDA is loved by management to offer some underlying picture of profit,’ says Markets.com analyst Neil Wilson. ‘But really investors should be looking at Pre-Tax Profits instead,’ he advises.
‘Often there are true one-off costs, like a restructuring charge or a huge investment, and on those occasions it is OK to focus on Underlying Profits.
‘But every company has its own version so it’s sometimes hard to compare,’ Wilson says.
AJ Bell’s Mould agrees: ‘I pay little or no attention to EBITDA, as it’s close to saying ‘earnings before bad stuff’.’
‘The trend in the last few years whereby companies produce ‘adjusted’ profits, stripping out bad things they don’t like to flatter the numbers – is reprehensible,’ Mould thunders.
Former retail chief and author of Reinventing Retail Ian Shepherd explains that start-ups often quote EBITDA, because in their early ‘build phase’ they have low earnings and very high expenditure.
‘But for everyone else, it is a pointless vanity measure,’ he adds.
In the words of business magnate Warren Buffett: ‘Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as EBITDA or pro forma they want you to unthinkingly accept concepts that are dangerously flawed.’
‘In golf my score is frequently below par on a pro forma basis. I have firm plans to ‘restructure’ my putting stroke and therefore only count the swings I take before reaching the green.’
To complicate matters further, there’s no one-size-fits-all scenario. The preferred or most useful profit figure can vary depending on the particular sector, or even from company to company.
For example, oil companies like BP often point to .
RCP takes into account the unique volatility of oil prices and the amount of oil the company can stock from one reporting period to another.
Broadly speaking however, bondholders, lenders and creditors will be most interested in everything down to Operating Profit, Mould says, ‘as this is what interest is paid out of and is the part of the profit and loss (P&L) account they therefore have a claim on’.
‘Meanwhile, shareholders will look to Pre-Tax Profit and EPS,’ he explains, as this is the portion of the P&L upon which they have a claim once important bills have been paid.