When lots of companies release results, this doesn’t just keep our share research team busy. It serves as a reminder for investors to take stock of any individual shares they own, and to make sure they really understand where the business stands.
Looking at profit is one way to do that.
When we talk about ‘profit' it can actually mean very different things.
Companies tend to focus on one type of profit when they report their results. That means it's important to understand what's actually going on underneath the varying titles. You shouldn't take a company's headline figure at face value.
When should you focus on pre-tax rather than operating profit? What does gross profit actually mean?
You might think learning about this kind of thing is really complicated and time consuming. We'd like to show you it's not.
This article isn't personal advice. If you're not sure if an investment is right for you make sure you ask for advice. All investments fall as well as rise in value. You could get back less than you invest.
Nothing gross about this metric
It makes sense to talk about gross profit first. It's the least filtered of all the profit types.
It's calculated by subtracting cost of goods sold (COGS) from revenue. COGS are the basic costs involved in producing a product, like raw materials and labour. It doesn't include indirect costs, like distribution of the goods.
As you can imagine, higher COGS will result in lower gross profit, you can see this in the table below.
| Company A | Company B | |
|---|---|---|
| Revenue | £1,000 | £1,000 |
| COGS | £300 | £500 |
| Gross profit | £700 | £500 |
Gross profit is a good starting point, and it's pretty quick to work out. This makes it a good tool if you're looking for a snappy sense check of a company's performance. But we rarely focus on gross profit.
That's because it excludes some important information. Running a business incurs a lot more than buying materials and paying people to put them together. If that's all it took, everyone would be a successful entrepreneur. Investors need to be particularly wary of focusing on gross profit in more complicated businesses – these types of companies are going to be relying a lot more on extra operating costs to keep the wheels turning.
So how do you factor operating costs in?
Operating costs include the costs involved in the extra day to day running of a business. This can include things like rent, repair and maintenance of equipment, money spent on marketing, office supplies and the heating bill.
Clearly, this is a more comprehensive overview of profits than gross profit. It gives you a real sense of how profitable a company's core operation is. That's why it's a metric we often talk about in our research.
To work it out, simply deduct operating costs from gross profit. You can find these things on the income statement. This sum will give you what's known as EBITDA, which stands for earnings before: interest, tax, depreciation and amortisation.
But, as with most things, it's sometimes worth digging a little deeper. This is a useful metric. But it's certainly not a one size fits all approach. EBITDA isn't the most appropriate measure for all businesses.
Digging deeper
Interest, tax, depreciation and amortisation are important costs of doing business.
Depreciation relates to the fact that physical assets like equipment, have a useful life. And just like when you buy a car or new phone, these items will lose value every year. Depreciation is a way to reflect how much value has been ‘used up' by that asset each year. Amortisation is the same concept, but it relates to non-physical things, like the value of a brand.
Including depreciation and amortisation charges is more important for companies with lots of physical assets. Companies that rely more heavily on equipment, like those that manufacture a lot, airlines or supermarkets (delivery vans don't come cheap!) should all arguably be including these charges when telling us how much profit they've made.
So, once depreciation and amortisation are factored in, you're left with EBIT. This is what you'll recognise as operating profit.
Operating profit is particularly useful because it gives you a truer sense of how much profit a company is really making. The biggest benefit for investors is that operating profit will tell you a lot about how well a company is controlling the costs within its control.
So…what about the "I" and the "T"?
We haven't forgotten about the interest and tax part of EBITDA.
Interest refers to the interest payable on loans. So if a company tends to carry more debt, it's important to consider what profits look like once this is included. It would be like trying to work out how much money you have left to spend in a month, while ignoring an outstanding interest charge on your credit card. Technically your salary's still the same, but you're not looking at the whole picture.
Once interest payments are factored in, you're left with profit before tax.
In terms of usefulness, this is similar to operating profit. But it's a more apt metric to look at for companies with significant interest payments – utilities are a good example here.
Of course if there's a before tax number, there's an after tax figure too. This is the true bottom line – you can't get any further down the income statement. As you'd expect, this number includes all of the above, but also deducts a company's tax expense.
In reality this number isn't too useful. While tax payments can be significant, it's not something a company can control. So, for a clearer understanding of what's going on operationally, you're better off looking at EBITDA, operating or pre-tax profit.
What to remember
A key thing to keep in mind with all these types of profit is that companies can be a little creative in what they characterise as a certain type of expense. No company will be exactly the same in its calculation. That's why to truly understand if a set of profit numbers looks good or bad, it's worth going back a few years to try and identify a trend. Remember though, past performance isn't a guide to what will happen in the future.
It's also always worth checking the full income statement for what's been characterised as an operating expense for example. But also having a quick sense check that nothing is glaringly missing or been included when it shouldn't.
The other factor is that just because a company hones in on a certain type of profit in their headline figures, doesn't mean it's the one you should focus on. For example, you should be asking questions if an asset-heavy company is intent on giving you an EBITDA figure. All of these metrics can be found in company results or annual reports, even if they're buried beyond the first page.
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