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The Anatomy of Profit

Although the term "fundamental" has become one of the most popular financial buzzwords of the last decade, very few investors truly understand what it means. In this article, we are going to focus on one of, if not the most, important fundamentals of all - earnings.

History is riddled with the remains of companies that held great promise and chic value, yet failed to actually make money. In the long run, profit is the only thing that matters. The recent demise of the dot-coms is evidence of the timeless principle that you can only go so far on ideals; at some point, that pesky thing called reality sets and you realize the rent and utilities need to be paid.

Sales and Revenue

The terms "sales" and "revenue" are interchangeable; they both refer to the gross amount of money brought in from business operations regardless of cost, liabilities, etc. This is what is known as the company's top line. It is used as a measure of the overall growth of a business.

 

Profit

Profit is the amount of money a company earns during a given fiscal period. It is calculated by subtracting from revenue all of the costs incurred during the fiscal year. For example, if a lemonade stand sold their product for $0.10 per cup, it cost $0.05 to manufacture, $0.01 cent to pay the employee who is running the stand, and $0.01 cent to pay taxes, the profit is $0.03 cents. It is what is left over after all of the expenses have been paid. This is the measure of true success, how much money a business generates for the owners. Profitability is measured by return on equity and return on assets.

 

Operating Margin

The operating margin is equal to operating income (earnings before income taxes and interest payments) divided by total revenue. It is used as a gauge for the earning power of a business.

 

Profit Margin

The profit margin is one of the most important numbers at your disposal because it can help gauge what it costs the company to make money. To find the profit margin, take the profit (after taxes) for the fiscal year and divide it by revenue. Companies with higher profit margins generally have to invest less capital back into the business to make money. The most common way to increase this number is to cut costs.

 

Earnings-Per-Share

Earnings-per-share (or EPS) are reported in two forms: basic and diluted. Basic EPS is calculated by divided reported net income by the average weighted shares outstanding. Diluted EPS is an adjusted number meant to show how much each share would have earned if the total number of shares outstanding increased due to stock options and convertible debt.

 

Price-to-Earnings Ratio

The price-to-earnings ratio tells an investor how much money he is paying for $1 of the company's earnings. In other words, if a company is reporting a profit of $2 per share, and the stock is selling for $20 per share, the P/E ratio is 10 because you are paying ten times earnings ($20 per share divided by $2 per share earnings = 10 P/E). For more information, read the article P/E Ratio: The Key to Understanding Value.

 

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization. In essence, it is the amount of money that would have been made if a company did not pay interest charges, taxes, depreciation, and amortization. By now you should be asking yourself, "how can you ignore those costs? They still exist even if you pretend they don't!"

Exactly! This is sort of like pretending that the interest you pay on your credit cards, your income taxes, and the depreciation on your car aren't real expenses to you. According to the EBITDA standards, they don't exist. If you can't tell, although you will hear a lot of professionals talking about this number, it is one of the most worthless, deceitful and meaningless figures available. Most investors are best served by paying absolutely no attention to it.

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