Week 2 profitability

Question 1

ROE

Answer 1

return on equity
= net income / equity
= (EBIT/invested capital) x (invested capital/ equity) x (net income/EBIT)
= ROIC x leverage x financial costs

= ROE = ROIC x financial leverage multiplier

ROE is determined by
- operating profitability
- financial policy (use of debt) > leverage and financial costs

• measures profitability from equity owners perspective: for each invested dollar, how much net income can a shareholder get

Question 2

ROIC

Answer 2

return on invested capital
= EBIT / invested capital
= (EBIT/sales) x (sales/ invested capital)

step to calculate:
- get EBIT from income statement
- construct economic BS: calculate WCR, net debt
- calculate ratio

• measures operating profitability
• most profitable if high

Question 3

EBIT/sales

Answer 3

= operating profit margin (EBIT margin)

*operating profit for 1eur of sales?

what influences this?
- competitiveness (monopolies are more profitable)
- quality of products/ services (Higher quality earns higher EBIT margin, on average)
- costs structure (high fixed costs decrease EBIT margin) (for example airline companies)

Question 4

sales/ invested capital

Answer 4

= capital turnover

• how efficient is the use of capitals to generate sales?

what influences this?
- WCR (low WCR, small inventories/ receivables and higher payables lead to higher turnovers)
- fixed assets (high fixed assets leads to low turnovers)

• low capital turnovers are usually associated with low EBIT margins

Question 5

relation between ROE and ROIC

Answer 5

• intuitively, tiger ROIC > higher ROE
• ROE is also affected by the interest expense (use of debt), because net income is an after-interest item

Question 6

leverage

Answer 6

= invested capital / equity
*ratio of financial structure
* is higher if its proportion of debt is higher

** leverage means reliance on debt as a funding source

Question 7

financial costs

Answer 7

= net income / EBIT

• measures interest costs as a ratio

Question 8

When to use ROIC and ROE

Answer 8

ROIC
- measures a firm’s overall ability to generate profit by its assets
- determined by a firm’s operating profit margin and capital turnover
- use: when you want to examine a firms overall profitability independent of the firm’s financial activity’s

ROE
- measures a firms profitability from equity holder’s perspective
- determined by a firm’s ROIC and financial policy
- use: when you care about the profit that goes to the shareholders after the impact of a firm’s financial activities

Question 9

other measures of profitability: EPS

Answer 9

earings per share
= net income / number of shares outstanding

Question 10

other measures of profitability: (P/E)

Answer 10

price-to-earnings ratio
= share price / EPS

Question 11

other measures of profitability: (M/B)

Answer 11

market-to-book ratio
= share price / book value per share

Question 12

different types of measures

Answer 12

market-based measures (EPS, P/E, M/B) contain forward-looking information
- Widely examined by investors
- Drawback: may contain irrational information

accounting measures (ROIC, ROE)
- accounting items are audited (hence more reliable)
- Drawback: Does past reflect future?