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Profitability is a fundamental measure of a company's financial health and performance. It reflects the ability of a business to generate earnings relative to its revenue, operating costs, and capital investments. It is a key indicator of financial success and sustainability. Profitability metrics are used by investors, analysts, and management to evaluate a company's performance over time and compare it with industry peers.

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Growth and Margins

But before discussing profitability, a very quick discussion on growth, which is ultimately the rate of increase (decrease) of a specific metric. Revenue growth measures the rate at which a company's sales or top-line income increases over time, whilst earnings growth refers to the rate at which a company's profits increase over time. Growth rates are ultimately revenues minus a series of costs and expenses divided by the same value in the previous period. There are a lot of fancy acronyms to represent earnings, based on what include and do not include as costs in the formula, the main three being: EBIT (Earnings Before Interest and Taxes) EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and NOPAT (Net Operating Income After Taxes). 

Whilst analysts and commentators may spend a decent amount of time discussing EBITDA (and maybe that’s why you may have heard this term in the past) we rather focus on the two other definitions: EBIT and NOPAT. The main reason why we do not like EBITDA is because we consider depreciations and amortizations actual costs and therefore we do not believe it is appropriate to consider the profitability of a company without taking these into account. In fact, EBITDA can give an overly optimistic view of profitability by excluding significant non-cash expenses, resulting in significant differences especially in the context of highly capital intensive industries. 

On the other hand, NOPAT includes the effect of taxes, but focuses only on the operational aspect of the business, excluding for instance other financial considerations: when buying a toy store we want to make sure first and foremost that they are good at selling toys, only then we would focus on how they manage their finances. The relationship between the two is: NOPAT = EBIT * (1 – tax rate).

The issue with accounting is that everyone likes to call variables as they like (or as they deem convenient) and therefore it is challenging from time to time to reconcile different financial statements. For example, to find the NOPAT and EBIT of Apple, one should first look at its annual report available here and then go to the Consolidated Statement of Operations. You won’t find any NOPAT and/or EBIT definitions, but after a while you should realise that EBIT is called Operating Income. On the other hand, at page 25 you will find that the effective tax rate of Apple is 24.1% and from there you can calculate NOPAT. One may be tempted to use Net Income as a proxy of NOPAT, but that includes non-operating income, so don’t. 

A first way to assess profitability is by looking at margins, which are measures of efficiency.

Gross Profit Margin: Measures the percentage of revenue remaining after deducting the cost of goods sold (COGS). It reflects the efficiency in turning raw materials into income. A stable high Gross Profit Margin indicates that the company has pricing power, namely that the company can sustainably keep a markup on its cost despite other factors (e.g. competition).

Operating Profit Margin: Indicates the percentage of revenue remaining after deducting operating expenses, such as wages, rent, and utilities. It reflects the efficiency of production processes.

Net Profit Margin: Represents the percentage of revenue remaining after all expenses, including taxes and interest, have been deducted. It reflects the efficiency of structure.

Rate of Returns

Rate of return and growth are the two variables that most impact the valuation of a company. To fully grasp the power of rate of return, let’s have a look at a simplified example where we have a company A with the following characteristics:

• Book Value = $5,

• Profitability:  ROE (Return On Equity) = 20% 

• Valuation: P/B (Price to Book) = x2, P/E (Price to Earnings) = x12

* assuming no distribution and 0% taxation

In Year 1, as the company has a profitability of 20%, it earns Book Value × ROE = $5 × 20% = $1. As the company does not pay any dividend, Book Value increases to $6 due to retained earnings. Assuming constant valuation metrics the company is now valued 2 x Book Value = $12 or 12 x Earnings = $12. In Year 2, the company has Earnings = $6 x 20% = $1.2, all Earnings again invested in the company therefore Book Value = $6 + $1.2 = $7.2 and a valuation now of $14.40.

The example highlights how a consistent 20% annual return leads to substantial growth in earnings, book value, and stock price over time. You may have also noticed that the changes in valuations are non linear and you are absolutely right because this is exactly how compounding works!

Now, how about if the rate of return is 18% or 22% instead of 20% for 10, 20, 30 years? What happens to our company’s Book Value?

This experiment demonstrates how even small variations in the rate of return significantly impact long-term book value. The power of compounding is evident, highlighting why investors should prioritise companies with strong, sustainable returns.  Now, let's explore how to effectively calculate a company's rate of return.