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Measuring profit in a world of one-offs

Earnings, profits and cash are among the most important measures of a company’s health and profitability
Investing 101

The Sage of Omaha, Warren Buffett, recently highlighted a growing issue within financial markets in his annual letter to shareholders, the idea of earnings versus profit. He drew attention to the fact that Berkshire Hathaway relies on ‘old-fashioned’ profits, not modern measures of ‘earnings’ that can be easily manipulated by boards and accountants.

Earnings, profits and cash are among the most important measures of a company’s health and profitability, but ultimately they are used to measure the ‘value’ of one company against another; therefore understanding how they are constructed is imperative for any serious investors. This isnt easy with more and more management teams ‘gaming’ the system through one-offs, or non-core operations.

Starting with earnings, many would assume this refers to the profit of a company, but it does not. The concept behind the earnings figure, is to strip out many costs, like the cost of debt and real assets, to get a better idea of a company’s operational performance. The most common measure of earnings is EBITDA or earnings before interest, tax, depreciation and amortisation.

  • EBITDA has traditionally been used to measure the financial performance of a company, but some view it as misleading because it strips out the cost of capital investments like property, plants and equipment, along with the impact of financing decisions through the cost of interest. On the other hand, many view depreciation and amortisation as simply being accounting deductions from profit, and hence believe excluding these provides a more accurate measure.

    One of the key benefits of EBITDA as a measure of profitability is the fact that it can be used more easily to compare valuations across companies and sectors. That is, by excluding the interest cost of highly levered industries like banking or utilities, one can make a fairer comparison against say a technology of healthcare company.

    There are a number of red flags for investors though, including when companies suddenly decide to focus on earnings rather than presenting their profit results prominently. This may be because they have leveraged heavily to prop up their business. In addition, the EBITDA result, being higher than profit in most cases, can make companies look cheaper than they actually are.

    Net profit, or net income as it is known in the US, is the traditional measure of profitability. That is, it considers all revenue and costs for a business, including interest, depreciation and extraordinary expenses like asset sales or purchases. It is by far the most useful measure of understanding how well a company is being managed.

    Profit figures are less easy to ‘game’ than earnings, with corporate decisions like borrowing and leasing, able to have a significant impact on the bottom line even when the revenue of a company is growing. As with earnings though, it isn’t always straightforward, with many Australian companies, including the banks, reporting underlying and statutory profit.

    Statutory refers to the legal profit, being the traditional measure of all revenue less all expenses, whilst underlying profit has many similarities to EBITDA. That is, underlying profit seeks to highlight the profitability of a company excluding one-offs like asset sales, writedowns and the like.

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