Measuring Profitability
James Dow
For GBUS 600Spring 2004
Outline
(1) Using financial statements to evaluate past profitability.
(2) Using financial statements to think about future performance.
(3) Using stock prices to think about future performance.
(1) Using financial statements to evaluate past profitability.
Useful when assessing management.
Perhaps useful for forecasting future.
Historical information is what you want.
Quick Overview of Financial Statements
Annual Report
Income Statement
Balance Sheet
Income Statement
Revenue
- Costs
= Earnings
Net Earnings or Income = Profits
Figure 1. Earnings, 1998-2001
-1500
-1000
-500
0
500
1000
1500
Weyerhaeuser Boise-Cascade Georgia-Pacific International PaperMil
lio
ns
1998
1999
2000
2001
Source: Company Annual Reports
Is $300 Million a Lot?
Profit margin (earnings/sales)?
What about earnings per share?
Return on equity (earnings/equity)
Balance Sheet
Assets = Liabilities + Equity
Equity is like “net worth”
“Book” (historical) value of equity
Figure 2. Return on Equity, 1999-2001
-15
-10
-5
0
5
10
15
20
25
30
35
Weyerhaeuser Boise-Cascade Georgia-Pacific International Paper
Per
cen
t
1999
2000
2001
Source: Company Annual Reports
Is 15% a Lot?
Opportunity cost of generating earnings.
Cost of capital
ROE – cost of equity
Problems with ROE
Only one period of earnings. Need longer history for evaluating past. Need future earnings for future.
Book value of equity vs. market value.
Can we get information from market value?
(2) Using financial statements to think about future performance.
This is a business question.
Historical financial information provides clues.
Market prices also provide information.
Income Statements in More Detail
Revenues - Costs of goods sold - Other costs (such as) Administrative Costs Research Costs Interest and Taxes Extraordinary Items
= Net Earnings
Why report different costs?
Why split out administrative costs?
Why split out extraordinary items?
Thinking about the Future
What will change?
How will that affect the financial position?
A quick comment on financial ratios.
(3) Using stock prices to think about future performance.
Stock price represents the value of a company.
The value of a company depends on future prospects.
Stock price depends on future prospects.
But how? We need a theory!
An oversimplified theory of stock prices
ROE = (total earnings)/(book equity)
Earnings yield = (total earnings)/(market
capitalization) = e/p (inverse of p/e ratio)
More Oversimplified Theory
e/p should equal opportunity cost of investing in stocks.
Changes in e produce changes in p.
Of course, it’s future e’s that really matter.
Things That Affect Stock Prices
Current and future earnings.
Risk of the particular stock.
Attitudes towards stock in general.
Attitudes towards saving in general.
Using Stock Prices
Use price information to judge earnings prospects.
How to separate firm specific factors from other forces?
Compare with the “average” behavior of stocks.
Figure 3. Relative Stock Performance: International Paper and S&P 500.
S&P500
International Paper
Conclusion
Know your question!
Use financial data to guide your investigations.
Use financial data to support your analysis.