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Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component in deciding whether to invest or to remain invested in a company. There are many metrics involved in calculating profitability, but for this article, I will look at Dollar Tree Incorporation's (NASDAQ:DLTR) 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 by comparing this summary to other companies in the same sector, you will be able see which has been the most profitable.

All material is sourced from Morningstar, and the Dollar Tree company webpage.

Earnings and Earnings Growth

1. Earnings = Sales x Profit Margin

  • 2010 - $5.882 billion x 6.75% = $397 million
  • 2011 - $6.631 billion x 7.35% = $488 million

Dollar Tree's earnings increased from $397 million in 2010 to $488 million in 2011, an increase of 22.92%.

2. Five-year historical look at earnings growth

  • 2007 - $201 million, 4.69% increase over 2006
  • 2008 - $230 million, 14.42% increase
  • 2009 - $321 million, 39.56% increase
  • 2010 - $397 million, 23.68% increase
  • 2011 - $488 million, 22.92% increase

In analyzing Dollar Tree's earnings over the past five years, it is evident that there has been a strong trend up.

In 2011, Dollar Tree had a record year. According to the company's 2011 annual report many factors resulted in the success of the year but the 1st factor listed was "Our stores, merchants and support teams are guided by a strategic vision that involves every element of the business
revolving around the customer."
Over the past 5 years, the company's earnings have increased by 242%.

Profit Margins

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. Here are ConocoPhillips gross profits for the past two years:

  • 2010 - $5.882 billion - $3.795 billion = $2.088 billion
  • 2011 - $6.631 billion - $4.252 billion = $2.378 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.).

In reviewing Dollar Tree's gross margin over the past five years, the margin has been increasing slightly over the past 5 years. The 5-year low for the gross margin was in 2008 with a margin of 34.27% while the high 5-year high was in 2011 with a margin of 35.86%. The 2011 gross profit margin is above the 5-year average of 35.11%.

  • 2007 - $1.461 billion / $4.243 billion = 34.43%
  • 2008 - $1.592 billion / $4.645 billion = 34.27%
  • 2009 - $1.857 billion / $5.231 billion = 35.50%
  • 2010 - $2.088 billion / $5.882 billion = 35.50%
  • 2011 - $2.378 billion / $6.631 billion = 35.86%

According to the 2011 annual report an aspect of the improvement in the 2011 gross margin was a result in "Improvement
in initial mark-up in many categories and occupancy
and distribution cost leverage were offset by an
increase in the mix of higher cost consumer product
merchandise and a smaller reduction in the shrink
accrual rate in fiscal 2011 than in fiscal 2010.
"

As the gross margin has been improving over the past 5 years this implies that management was more efficient in its manufacturing and distribution during the production process in 2011 compared to the 5-year average.

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, 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 - $4.049 billion
  • 2011 - $3.980 billion

6. Operating Margin = Operating Income / Total Sales

Operating margin is a measure of the proportion of a company's revenue that 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.

Over the past five years, Dollar Tree's operating margin has been consistently increasing. The 2011 operating margin of 11.79% is above the 5-year average of 9.59%.

  • 2007 - $330 million / $4.243 billion = 7.77%
  • 2008 - $366 million / $4.645 billion = 7.88%
  • 2009 - $513 million / $5.231 billion = 9.81%
  • 2010 - $630 million / $5.882 billion = 10.71%
  • 2011 - $782 million / $6.631 billion = 11.79%

As the operating margin has been increasing over the past few years, this implies that there has been an increase in the percentage of total sales left over after paying for variable costs of production such as wages and raw materials.

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.

Dollar Tree's net profit margin has shown a steady increase since 2007. In 2007 the net profit margin was calculated at 4.74% while the 2011 net profit margin was calculated at 7.36%. The 2011 net profit margin of 7.36% is above the 5-year average of 5.96%.

  • 2007 - $201 million / $4.243 billion = 4.74%
  • 2008 - $230 million / $4.645 billion = 4.95%
  • 2009 - $321 million / $5.231 billion = 6.03%
  • 2010 - $397 million / $5.882 billion = 6.75%
  • 2011 - $488 million / $6.631 billion = 7.36%

In 2010 one of the main factors that has been listed as aiding in the increase in the net profit margin was the increase in comparable store net sales and sales in their new stores.

As the 2011 net profit margin of 7.36% is above the 5 year average of 5.96%, this implies that there has been an increase in the percentage of earnings that the company is able to keep compared to the company's 5-year average.

Profitability Ratios

8. 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."

Like the Profit margins listed above, the ROA has been steadily increasing. The 2011 ROA of 20.95% is above the 5-year average of 14.83%.

  • 2007 - $201 million / $1.788 billion = 11.24%
  • 2008 - $230 million / $2.036 billion = 11.30%
  • 2009 - $321 million / $2.290 billion = 14.02%
  • 2010 - $397 million / $2.381 billion = 16.67%
  • 2011 - $488 million / $2.329 billion = 20.95%

The 2011 ROA of 20.95% is well above the 5-year average of 14.83%. As the ROA is above the 5 year average, this implies that management has been more efficient at using the company's assets to generate earnings compared to its 5-year average.

9. ROE - Return on Equity = Net Income / Shareholders' Equity

As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.

  • 2007 - $201 million / $988 million = 20.34%
  • 2008 - $230 million / $1.253 billion = 18.35%
  • 2009 - $321 million / $1.429 billion = 22.46%
  • 2010 - $397 million / $1.459 billion = 27.21%
  • 2011 - $488 million / $1.345 billion = 36.28%

Dollar Tree's ROE has also been steadily increasing over the past 5 years. There is one exception where in 2008 the ROE declined. As the 2011 ROE is high, this reveals that the company is generating a strong amount profits compared to shareholders' equity.

Cash Flows

10. Free Cash Flow = Operating Cash Flow - Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (NYSE: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.

Over the past five years, Dollar Tree's free cash flow has remained positive.

  • 2007 - $367 million - $196 million = $172 billion
  • 2008 - $403 million - $131 million = $272 billion
  • 2009 - $581 million - $165 million = $416 billion
  • 2010 - $519 million - $179 million = $340 billion
  • 2011 - $687 million - $250 million = $436 billion

The latest number, on the plus side, indicates that Dollar Tree has enough cash to develop new products, make acquisitions, and reduce debt.

11. 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, it shows up as a negative number in the numerator in the cash flow margin equation. This means that even as the company 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.

As Dollar Tree's cash flow margin is positive, it does not have to take the above measures to continue operating.

  • 2007 - $367 million / $4.243 billion = 8.65%
  • 2008 - $403 million / $4.645 billion = 8.68%
  • 2009 - $581 million / $5.231 billion = 11.11%
  • 2010 - $519 million / $5.882 billion = 8.82%
  • 2011 - $687 million / $6.631 billion = 10.36%

Summary

In analyzing Dollar Tree's earnings growth over the past five years, you can see the earnings have been increasing steadily. One of the reasons for this improvement listed in the 2011 annual report was the "strategic vision that involves every element of the business revolving around the customer." This current strategy has paid off as the earnings have increased year over year for the past 5 years.

As illustrated above and using a 5-year time frame, the listed profit margins also show a positive upward trend. All the listed profit margins are above their 5 year averages.

The ROA and ROE show very similar results to the earnings and profit margins. Both have shown a steady increase over the past 5 years.

With free cash flow and the free cash flow margin both displaying positive cash, Dollar Tree has enough cash to develop new products, make acquisitions, and reduce debt without having to borrow or raise money to maintain operations.

The analysis of Dollar Tree's profitability reveals a very strong company with increasing profitability margins and earnings, with positive cash and cash flow.

For another article on Dollar Tree please read:

Dollar Tree: Inside The Numbers

For an excellent article by another author please read:

Weak Economy Positions Dollar Tree For Strong Growth

Source: Dollar Tree: Profitability Analysis