Profitability and Return on Investment Chapter 10 Profitability and Return on Investment

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

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

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

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

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

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

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

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

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