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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 National Oilwell Varco Inc. (NYSE:NOV) 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 Company webpage.

Earnings and Earnings Growth

1. Earnings = Sales x Profit Margin

  • 2010 - $12.156 billion x 13.71% = $1.667 billion
  • 2011 - $14.658 billion x 13.60% = $1.994 billion

National Oilwell's earnings increased from $1.667 billion in 2010 to $1.994 billion in 2011, an increase of 19.62%.

2. Five-year historical look at earnings growth

  • 2007 - $1.337 billion, 95.46% increase over 2006
  • 2008 - $1.952 billion, 45.99% increase
  • 2009 - $1.469 billion, 24.74% decrease
  • 2010 - $1.667 billion, 13.63% increase
  • 2011 - $1.994 billion, 19.62% increase

In looking at National Oilwell's earnings over the past five years, you can see how the economic crisis affected the earnings in 2009. In 2009 the company's earnings decreased by 24.74% compared to 2008. Even though the earnings decreased by 24.74% they were still a strong number at $1.469 billion. Since 2008 the company has been showing strong signs of recovery and in 2011 the company reported earnings of $1.994 billion. This amount surpassed the 2008 peak reported earnings of $1.952 billion.

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 National Oilwell's gross profits for the past two years:

  • 2010 - $12.156 billion - $8.324 billion = $3.832 billion
  • 2011 - $14.658 billion - $10.161 billion = $4.497 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 National Oilwell's gross margin over the past five years, the margin has been relatively the same. The 5-year low for the gross margin was reported in 2007 with a margin of 28.91%. The 5-year high for the margin was in 2010 with a margin of 31.52%. The 2011 gross profit margin of 30.68% is slightly above the 5-year average of 30.23%.

  • 2007 - $2.830 billion / $9.789 billion = 28.91%
  • 2008 - $4.072 billion / $13.431 billion = 30.31%
  • 2009 - $3.784 billion / $12.712 billion = 29.77%
  • 2010 - $3.832 billion / $12.156 billion = 31.52%
  • 2011 - $4.497 billion / $14.658 billion = 30.68%

As the gross margin has been consistently around the 30% mark over the past 5 years this implies that management has been consistent in its efficiency of the company's manufacturing and distribution during the production process over the past 5 years.

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 - $2.447 billion
  • 2011 - $2.937 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, National Oilwell's operating margin reveals a dip in 2009 but a recovery back to the 20% range for 2010 and 2011. In four of the past 5 years the operating margin has been around 20%.

  • 2007 - $2.044 billion / $9.789 billion = 20.88%
  • 2008 - $2.918 billion / $13.431 billion = 21.72%
  • 2009 - $2.315 billion / $12.712 billion = 18.21%
  • 2010 - $2.447 billion / $12.156 billion = 20.13%
  • 2011 - $2.937 billion / $14.658 billion = 20.04%

The 2011 operating margin of 20.04% is slightly below the 5-year average of 20.19%. This implies that there has been a slightly less percentage of the total sales left over after paying for variable costs of production such as wages and raw materials compared to the 5-year average.

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.

Like the Operating Margin, National Oilwell's net profit margin revealed a dip in 2009 and a recovery up to around the 5 year average. In this case, the 2011 net profit margin of 13.60% is slightly above the 5-year average of 13.42%.

  • 2007 - $1.337 billion / $9.789 billion = 13.66%
  • 2008 - $1.952 billion / $13.431 billion = 14.53%
  • 2009 - $1.469 billion / $12.712 billion = 11.56%
  • 2010 - $1.667 billion / $12.156 billion = 13.71%
  • 2011 - $1.994 billion / $14.658 billion = 13.60%

As the 2011 net profit margin of 13.60% is above the 5-year average of 13.42%, 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."

The 2011 ROA of National Oilwell has not exceeded the 2007 ROA of 11.03% but has shown a recovery from the 2009 low of 6.82%. The 2011 ROA of 7.82% is below the 5-year average of 8.39%.

  • 2007 - $1.337 billion / $12.115 billion = 11.03%
  • 2008 - $1.952 billion / $21.479 billion = 9.09%
  • 2009 - $1.469 billion / $21.532 billion = 6.82%
  • 2010 - $1.667 billion / $23.050 billion = 7.23%
  • 2011 - $1.994 billion / $25.515 billion = 7.82%

As the 2011 ROA of 7.82% is below the 5-year average of 8.39%, this implies that management has been less 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 - $1.337 billion / $6.661 billion = 20.01%
  • 2008 - $1.952 billion / $12.628 billion = 15.46%
  • 2009 - $1.469 billion / $14.113 billion = 10.41%
  • 2010 - $1.667 billion / $15.748 billion = 10.59%
  • 2011 - $1.994 billion / $17.619 billion = 11.32%

Like the ROA National Oilwell's ROE has rebounded from the 2009 recession. As the 2011 ROE has rebounded, this reveals a recovery but the 2011 ROA of 11.32% is still below the 5 year average of 13.55%.

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 (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, National Oilwell's free cash flow has remained positive.

  • 2007 - $1.188 billion - $252 million = $936 million
  • 2008 - $2.294 billion - $379 million = $1.916 billion
  • 2009 - $2.095 million - $250 million = $1.845 billion
  • 2010 - $1.542 billion - $232 million = $1.310 billion
  • 2011 - $2.143 billion - $483 million = $1.660 billion

The latest number, on the plus side, indicates that National Oilwell Varco has enough cash to develop new products, make acquisitions, pay dividends 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 National Oilwell Varco's cash flow margin is positive, it does not have to take the above measures to continue operating.

  • 2007 - $1.188 billion / $9.789 billion = 12.14%
  • 2008 - $2.294 billion / $13.431 billion = 17.08%
  • 2009 - $2.095 million / $12.712 billion = 16.48%
  • 2010 - $1.542 billion / $12.156 billion = 12.69%
  • 2011 - $2.143 billion / $14.658 billion = 14.62%

Summary

In looking at National Oilwell's earnings over the past five years, you can see how the economic crisis affected the earnings in 2009. In 2009 the company's earnings decreased by 24.74% compared to 2008. Even though the earnings decreased by 24.74% they were still a strong number at $1.469 billion. Since 2008 the company has been showing strong signs of recovery and in 2011 the company reported earnings of $1.994 billion. This amount surpassed the 2008 peak reported earnings of $1.952 billion.

As illustrated above and using a 5-year time frame, the listed profit margins are showing a recovery since 2009. In 2011 the gross profit margin exceeded the 2007 results while the operating and the net profit margins are still just below their 2007 results. Over the past 5 years the gross, operating and net profit margins or National Oilwell Varco Inc. are showing good results.

The ROA and ROE indicate similar results. Both the ROA and ROE indicate a strengthening in the profitability of the company after the crisis in 2008 / 2009, but are still down from the company's peak ROA and ROE's in 2007.

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

The analysis of National Oilwell Varco's profitability indicates a very strong company that is recovering from its 2009 lows. Over the past five years, the earnings as well as the other listed profitability margins and ratios have rebounded nicely. These trends show strong signals for the future as National Oilwell has a strong amount of free cash at hand, which means the company will likely continue to grow for the foreseeable future.

Source: National Oilwell Varco Inc. Profitability Analysis