The Art of Company Valuation and Financial Statement Analysis: A Value Investor's Guide with Real-life Case Studies

Chapter 2

Key Ratios for Return and Profitability

Time is the enemy of the poor business and the friend of the great business. If you have a business that’s earning 20%–25% on equity, time is your friend. But time is your enemy if your money is in a low-return business.

Warren E. Buffett

 

Profit maximization is one of the foremost targets in business. Profit arises when capital is deployed in uncertain circumstances. A baker for example needs a shop, a bakery and raw materials to carry out the operational activity using this capital in order to make a profit. Hence, to measure the success of an enterprise one has to consider both sides of the equation: profit and required capital. The bigger the profit and the smaller the required capital base, the more profitably the business will run. Profitability is therefore an important success measure in company valuation.

This chapter addresses the question of how profitability is measured and how meaningful the results are. Several key profitability ratios, which serve as basic tools in the valuation process, will be explained with the help of case studies. Net profit is the most commonly used performance indicator. However, the meaningfulness of the conclusions about the value of a company is limited as long as net profit is not set in relation to other indicators. The development of two fictional companies’ group earnings sheds more light on this issue.

Example 2.1 – Profitability

Besides data shown in Table 2.1, both companies are ...