Looking at a company's profitability is a very important step in understanding the company. Profitability is essentially why the company exists and is a key component while deciding to invest or to stay invested in a company. There are many metrics involved in calculating profitability, but for this test, I will look at ABB LTD's (ABB) Earnings and Earnings Growth, Profit Margins, Profitability Ratios and Cash Flow.
Through the above-mentioned four main metrics, we will understand more about the company's profitability and if this summary is compared with other companies in the same sector, you will be able see which has been the most profitable.
Earnings and Earnings Growth
1. Earnings = sales x profit margin
- 2010 - $31.589 billion x 8.11% = $2.561 billion
- 2011 - $37.990 billion x 8.33% = $3.168 billion
ABB LTD's earnings increased from $2.561 billion in 2010 to $3.168 billion in 2011 or by 23.7%.
2. Five-year historical look at earnings growth
- 2007 - $3.611 billion,
- 2008 - $3.118 billion, 15.81% decrease
- 2009 - $2.901 billion, 7.48% decrease
- 2010 - $2.561 billion, 13.27% decrease
- 2011 - $3.168 billion, 23.70% increase
In analyzing the earnings growth of ABB LTD over the past five years, you see ABB's earnings have decreased year over year more than they have increased. In 2011 the earnings have increased by 23.70% over 2010 showing a nice rebound. Over the past few years ABB's earnings have been decreasing but in 2011 the earnings increased by 23.70% to end up 13.98% lower than 2007.
3. Gross Profit = Total sales - cost of sales
In analyzing a company, gross profit is very important because it indicates how efficiently management uses labor and supplies in the production process. More specifically, it can be used to calculate gross profit margin.
- 2010 - $31.589 billion - $22.060 billion = $9.529 billion
- 2011 - $37.990 billion - $26.556 billion = $11.434 billion
4. Gross Profit Margin = Gross Income / Sales
The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/ sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.)
- 2007 - $8.968 billion / $29.183 billion = 30.73%
- 2008 - $10.940 billion / $34.912 billion = 31.33%
- 2009 - $9.325 billion / $31.795 billion = 29.32%
- 2010 - $9.529 billion / $31.589 billion = 30.17%
- 2011 - $11.434 billion / $37.990 billion = 30.09%
In looking at the gross margin over the past 5 years we see very consistent results. The highest margin was in 2008 at 31.33% while the lowest margin was in 2009 at 29.32%. This implies that management has been very consistent in their efficiency of manufacturing and distribution during the production process.
5. Operating income = Total sales - operating expenses
The amount of profit realized from the operations of a business after taking out operating expenses - such as cost of goods sold (COGS) or wages - and depreciation. Operating income takes the gross income (revenue minus COGS) and subtracts other operating expenses and then removes depreciation. These operating expenses are costs that are incurred from operating activities and include things such as office supplies and heat and power.
- 2010 - $3.818 billion
- 2011 - $4.667 billion
6. Operating Margin = operating income / total sales
Operating margin is a measure of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.
If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.
- 2007 - $4.023 billion / $29.183 billion = 13.79%
- 2008 - $4.552 billion / $34.912 billion = 13.03%
- 2009 - $4.126 billion / $31.795 billion = 12.97%
- 2010 - $3.818 billion / $31.589 billion = 12.09%
- 2011 - $4.667 billion / $37.990 billion = 12.28%
Over the past 5 years ABB LTD's operating margin has been slowly declining except for 2011 when it rebounded up to 12.28%. When the operating margin is slipping it implies that there is less of a percentage of total sales left over for paying for variable costs of production such as wages, raw materials, etc.
7. Net Profit Margin = Net income / total sales
A ratio of profitability calculated as net income divided by revenue, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.
Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.
- 2007 - $3.611 billion / $29.183 billion = 12.37%
- 2008 - $3.118 billion / $34.912 billion = 8.93%
- 2009 - $2.901 billion / $31.795 billion = 9.12%
- 2010 - $2.561 billion / $31.589 billion = 8.10%
- 2011 - $3.168 billion / $37.990 billion = 8.34%
ABB's net profit in 2011 increased compared to 2010 but is still below the 5 year average of 9.37%. The current net profit margin of 8.34% is slightly below the industry average of 8.46%.
8. SG&A % Sales = SG&A / total sales
Reported on the income statement, it is the sum of all direct and indirect selling expenses and all general and administrative expenses of a company.
High SG&A expenses can be a serious problem for almost any business. Examining this figure as a percentage of sales or net income compared with other companies in the same industry can give some idea of whether management is spending efficiently or wasting valuable cash flow.
- 2007 - $4.104 billion / $29.183 billion = 14.06%
- 2008 - $4.795 billion / $34.912 billion = 13.73%
- 2009 - $4.491 billion / $31.795 billion = 14.12%
- 2010 - $4.615 billion / $31.589 billion = 14.60%
- 2011 - $5.373 billion / $37.990 billion = 14.14%
As the SG&A % Sales decreased compared to 2010, it implies that management is spending more efficiently. Over the past 5 years the SG & A sales percentage has been very consistent with an average 14.13%. This implies that management has been very consistent in their sum of all direct and indirect selling expenses.
9. ROA - Return on Assets = Net income / total assets
ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."
- 2007 - $3.611 billion / $31.001 billion = 11.64%
- 2008 - $3.118 billion / $33.011 billion = 9.44%
- 2009 - $2.901 billion / $34.728 billion = 8.35%
- 2010 - $2.561 billion / $36.295 billion = 7.06%
- 2011 - $3.168 billion / $39.648 billion = 8.00%
In looking at the ROA over the past 5 years we can see the ratio has declined 4 of the past 5 years. The 5 year average for the Return on Assets is 8.99%. As the current ROA of 8.0% is less than the 5 year average this implies that management was less efficient at using its assets to generate earnings compared to their 5 year average.
10. ROE - Return on Equity = Net income / shareholder's equity
As shareholder's equity is measured as a firm's total assets minus its total liabilities it reveals the amount of net income returned as a percentage of shareholders equity. The return on equity measures a corporation's profitability by revealing how much profit a company generates with the amount shareholder's are invested.
- 2007 - $3.611 billion / $10.957 billion = 32.95%
- 2008 - $3.118 billion / $11.158 billion = 27.94%
- 2009 - $2.901 billion / $13.790 billion = 21.02%
- 2010 - $2.561 billion / $14.885 billion = 17.21%
- 2011 - $3.168 billion / $15.777 billion = 20.08%
As the ROE increased from 22.09% in 2010 to 23.84% in 2011, it reveals that the company is generating more profits when compared to the shareholder's equity. The company's 2011 ROE is below with the 5 year average of 23.84%.
11. Free Cash Flow = operating cash flow - capital expenditure
A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.
It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.
- 2007 - $3.093 billion - $756 million = $2.337 billion
- 2008 - $3.984 billion - $1.171 billion = $2.813 billion
- 2009 - $4.027 billion - $967 million = $3.06 billion
- 2010 - $4.197 billion - $840 million = $3.357 billion
- 2011 - $3.612 billion - $1.021 million = $2.591 billion
Even though the ABB's free cash flow has decreased by 29.56% compared to 2010, it is not of concern as ABB still has 2.591 billion in free cash. As the latest number is positive it implies that ABB has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.
12. Cash flow margin = Cash flow from operating activities / total sales
The higher the percentage, the more cash available from sales.
If a company is generating a negative cash flow, which would show up as a negative number in the numerator in the cash flow margin equation, then even as it is generating sales revenue, it is losing money. The company will have to borrow money or raise money through investors in order to keep on operating.
- 2007 - $3.093 billion / $29.183 billion = 10.60%
- 2008 - $3.984 billion / $34.912 billion = 11.41%
- 2009 - $4.027 billion / $31.795 billion = 12.67%
- 2010 - $4.197 billion / $31.589 billion = 13.29%
- 2011 - $3.612 billion / $37.990 billion = 9.50%
As the company's cash flow margin is positive, it does not have to borrow money or raise money to keep operating.
In analyzing the earnings growth of ABB LTD over the past five years, you see ABB's earnings have decreased more than they have increased. In 2011 the earnings increased by 23.70% over 2010 showing a nice rebound. Over the past few years ABB's earnings have been decreasing but in 2011 the earnings increased by 23.70% to end up 13.98% lower than 2007.
As illustrated above, the listed profit margins have shown mixed results. The Gross profit margin and the SG&A % to sales have been very consistent over the past 5 years while the operating margin and net profit margin have been slipping with the exception of 2011.
As the ROA and ROE are relatively consistent, this implies that management is efficient at using its assets and equity to generate earnings.
As the free cash flow and the free cash flow margin both display positive cash, this indicates that ABB LTD has enough cash to develop new products, make acquisitions, pay dividends and reduce debt without having to borrow or raise money to keep operating.
In analyzing ABB LTD's profitability, it displays mixed results. Over the past 5 years the earnings and some of the margins have been declining but 2011 displayed good results over 2010 changing some of the trends. Based on the above information, it would be good to see the earnings and the declining margins continue 2011's trend upward and display positive earnings over the previous year.
For more fundamental analysis on ABB please read my article: ABB Ltd: Inside The Numbers
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.