INSIGHTS

To those newer to investing, and even for those who have been doing it for some time, the raft of different profit numbers used by companies and analysts can be daunting.

For example, is it better to look at net profit or operating profit? What about statutory profit vs. underlying profit? And how do we account for currency movements when analysing how well a company is doing?

In this post we step through the different profit numbers companies and analysts may use, and explain the circumstances in which each may be preferred.

The different profit numbers

The most common profit numbers investors will see are:

• net profit after tax (NPAT) - the profit the company made after all expenses have been deducted. This usually gives a fair indication of the amount of money that is available to be paid out to shareholders in the form of dividends, or reinvested in the company to drive future growth.
• earnings before interest and tax (EBIT) - this measures the operating earnings excluding the non-operating costs of interest and tax.
• earnings before interest, tax, depreciation and amortisation (EBITDA) - this measures the operating earnings excluding the non-operating costs of interest, tax, depreciation and amortisation. Amortisation is a form of depreciation for intangible assets such as goodwill.

So when would we be interested in looking at operating profit over NPAT?

Operating profit (EBIT and EBITDA) can be preferable when comparing companies across an industry as it controls for different capital structures (the mix of debt and equity) and consequent different interest costs between companies.

It may also be more suitable for those companies with abnormally large depreciation charges like infrastructure and utilities where the NPAT number can become meaningless.

Statutory profit vs. underlying profit

Another thing that trips up some investors is the use of underlying (or normalised) profit numbers as compared to statutory profit numbers (i.e. those derived from following accounting standards). The difference is that, in arriving at the underlying profit number, a company may include or exclude certain items, for example, one-off costs or revaluation gains.

We should always be a little cautious when a company uses an underlying profit number – it may be an attempt to hide something to make the profit number more flattering. However, there are also valid reasons why an underlying profit number may be preferable. For example, due to large property revaluation gains, the statutory profit for New Zealand retirement village operators can swing largely year to year.

Excluding these gains and using an underlying profit number instead provides investors with a much better reflection of how the business is tracking.

Accounting for currency movements

Something else investors may come across is the use of constant currency profit figures. For example, we may say a company grew NPAT by 10% in constant currency terms even if reported profit was up by 15%.

As a large number of companies derive profits in many different currencies, this is another attempt to convey how well the company has performed operationally by ignoring sometimes large swings in currency.

Conclusion

The best profit number to use varies from industry to industry and company to company. As with most things in investing, it is more an art than a science and comes with time.

We must also be aware that companies may choose measures that suit them. We use a range of measures and other qualitative factors in our analysis of the performance of a company, including looking at cash flow generation which is much harder to massage.