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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 Chevron Corporation's (CVX) 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 - $204.928 billion x 10.77% = $19.024 billion
  • 2011 - $253.706 billion x 10.66% = $26.895 billion

Chevron's earnings increased from $19.024 billion in 2010 to $26.895 billion in 2011, an increase of 41.37%.

2. Five-year historical look at earnings growth

  • 2007 - $18.688 billion, 9.0% increase over 2006
  • 2008 - $23.931 billion, 28.05% increase
  • 2009 - $10.483 billion, 128.28% decrease
  • 2010 - $19.024 billion, 81.47% increase
  • 2011 - $26.895 billion, 41.37% increase

In looking at Chevron'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 128.28%. Even though the earnings decreased by over one hundred percent they still held up quite well with the company posting earnings of $10.483 billion. Since the low in 2009 the company has been showing strong signs of recovery and in 2011 the company reported earnings of $26.895 billion. This amount surpassed the 2008 peak reported earnings of $23.931 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 Chevron's gross profits for the past two years:

  • 2010 - $204.928 billion - $116.467 billion = $88.461 billion
  • 2011 - $253.706 billion - $149.923 billion = $103.783 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 Chevron's gross margin over the past five years, we can see a significant increase in the margin. The 5-year low for the gross margin was reported in 2007 with a margin of 31.39%. The 5-year high for the margin was in 2010 with a margin of 43.17%. The 2011 gross profit margin of 40.90% is above the 5-year average of 37.31%.

  • 2007 - $69.340 billion / $220.904 billion = 31.39%
  • 2008 - $79.644 billion / $273.005 billion = 29.17%
  • 2009 - $71.983 billion / $171.636 billion = 41.94%
  • 2010 - $88.461 billion / $204.928 billion = 43.17%
  • 2011 - $103.783 billion / $253.706 billion = 40.90%

As the gross margin has been improving over the past 5 years this implies that management has been getting more efficient in 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, Chevron's operating margin reveals a dip in 2009 but a recovery back to 18.78% in 2011. The 2011 operating margin of 18.78% exceeded the 2008 peak of 15.73%.

  • 2007 - $32.167 billion / $220.904 billion = 14.56%
  • 2008 - $42.957 billion / $273.005 billion = 15.73%
  • 2009 - $18.528 billion / $171.636 billion = 10.79%
  • 2010 - $32.055 billion / $204.928 billion = 15.64%
  • 2011 - $47.634 billion / $253.706 billion = 18.78%

The 2011 operating margin of 18.78% is above the 5-year average of 15.10%. This implies that there has been a higher 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, Chevron's net profit margin revealed a dip in 2009 and a strong recovery up exceeding the 2008 peak. In this case, the 2011 net profit margin of 10.60% is well above the 5-year average of 8.64%.

  • 2007 - $18.688 billion / $220.904 billion = 8.46%
  • 2008 - $23.931 billion / $273.005 billion = 8.77%
  • 2009 - $10.483 billion / $171.636 billion = 6.11%
  • 2010 - $19.024 billion / $204.928 billion = 9.28%
  • 2011 - $26.895 billion / $253.706 billion = 10.60%

As the 2011 net profit margin of 10.60% is above the 5-year average of 8.64%, 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 Chevron has not rebounded enough over the past couple of years to exceed the 2008 peak ROA of 14.85% but the 2011 ROA of 12.84% is above the 5-year average of 11.39%.

  • 2007 - $18.688 billion / $148.786 billion = 12.56%
  • 2008 - $23.931 billion / $161.165 billion = 14.85%
  • 2009 - $10.483 billion / $164.621 billion = 6.38%
  • 2010 - $19.024 billion / $184.769 billion = 10.30%
  • 2011 - $26.895 billion / $209.474 billion = 12.84%

As the 2011 ROA of 12.84% is above the 5-year average of 11.39%, 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 - $18.688 billion / $77.088 billion = 24.24%
  • 2008 - $23.931 billion / $86.648 billion = 27.62%
  • 2009 - $10.483 billion / $91.914 billion = 11.41%
  • 2010 - $19.024 billion / $105.081 billion = 18.10%
  • 2011 - $26.895 billion / $121.382 billion = 22.16%

Chevron's ROE has revealed a dip in 2009. Over the past three years, the ROE has rebounded. As the ROE has gained strength over the past three years, this reveals that there has been an increase in how much profit has been generated compared to the amount that shareholders have invested.

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 four of the past five years, Chevron's free cash flow has remained positive.

  • 2007 - $24.977 billion - $16.678 billion = $8.299 billion
  • 2008 - $29.632 billion - $19.666 billion = $9.966 billion
  • 2009 - $19.373 billion - $19.843 billion = $-470 million
  • 2010 - $31.359 billion - $19.612 billion = $11.747 billion
  • 2011 - $41.098 billion - $26.500 billion = $14.598 billion

The latest number, on the plus side, indicates that Chevron 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 Chevron's cash flow margin is positive, it does not have to take the above measures to continue operating.

  • 2007 - $24.977 billion / $220.904 billion = 11.31%
  • 2008 - $29.632 billion / $273.005 billion = 10.85%
  • 2009 - $19.373 million / $171.636 billion = 11.29%
  • 2010 - $31.359 billion / $204.928 billion = 15.30%
  • 2011 - $41.098 billion / $253.706 billion = 16.20%

Summary

In looking at Chevron'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 128.28%. Even though the earnings decreased by over one hundred percent they still held up quite well with the company posting earnings of $10.483 billion. Since the low in 2009 the company has been showing strong signs of recovery and in 2011 the company reported earnings of $26.895 billion. This amount surpassed the 2008 peak reported earnings of $23.931 billion.

As illustrated above and using a 5-year time frame, the listed profit margins are showing signals of a strong recovery since 2009. In 2011 all listed profit margin exceeded the 2007 results. This is indicating a strong recovery and also indicating that the company is increasing its profit margins.

The ROA and ROE indicate similar results in that both the ROA and ROE are showing strengthening in the profitability of the company after the crisis.

With free cash flow and the free cash flow margin both displaying positive cash, Chevron 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 Chevron's profitability indicates a very strong company that is recovering from its 2009 lows and gaining strength moving forward. Over the past five years, the earnings as well as the other listed profitability margins and ratios have rebounded nicely and have exceeded the previous 5 year peaks. These trends show strong signals for the future as Chevron has a strong amount of free cash at hand, which means the company will likely continue to grow for the foreseeable future.

To read more articles on Chevron please read: Analyzing Chevron's Debt And Risk and Chevron: Inside The Numbers.

Source: Chevron: Profitability Analysis