1. Profitability and Return on Investment
Chapter 10
Profitability and Return on Investment

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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