The Bottom Line
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
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
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
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 (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.
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 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.