Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 138

Judging big profits beyond the big headlines

Over the last month, Westpac, NAB and ANZ collectively reported profits of $20.8 billion. This resulted in commentary in the media about banks being too profitable, especially in light of recent moves to reprice loan rates upwards for both investors and owner occupiers. Whilst large corporations generate big profits in dollar terms, debate often ignores the extent to which these profits have to be shared amongst millions of individual shareholders. For example, Commonwealth Bank has 790,000 shareholders with 1.7 billion shares outstanding, all of which have a claim over the $9.1 billion in cash profit that the bank reported in August. This article looks at different measures of corporate profitability for large Australian listed companies, beyond the billion dollar headlines.

Different measures of profitability

As a fund manager, the $7.8 billion of raw profit generated by Westpac does not mean much. I look at the underlying earnings per share (EPS) which is what the owner of a single share of the company receives from the profit generated in a particular year. We also look at growth in EPS, as often a company’s profits can grow substantially when they make an acquisition, but if that acquisition is funded by issuing a large number of additional shares, profit per share might not actually grow. For example, in 2015, toll road operator Transurban reported revenue growth of 39.6% post the acquisition of Queensland Motorways, sensational growth for a steady business. However, distribution per share grew at a still respectable 14% after issuing additional shares to fund the purchase of the new asset. Additionally, at a company level we also look at measures such as returns and profit margins, which can be better measures of how efficient a company’s management team is in generating the annual profits. Furthermore, these measures allow the investor to compare different companies in similar industries.

Return on Equity

Return on Equity (ROE) looks at the profit being generated by the equity that the owners have contributed to establish the business. ROE is calculated by dividing a company’s profit by the money which shareholders have invested in it. This investment by shareholders includes both original share capital from the IPO plus retained earnings. Retained earnings are the profits kept by the company in excess of dividends and are used to fund capital expenditure to either maintain or grow the company. Companies with high ROE typically require little in the way of dilutive equity raisings from shareholders to run their business, or may be highly geared.

The chart above shows the top and bottom five companies in the ASX as ranked by ROE. The top ROE earners contain a fund manager (Magellan), an internet company (Carsales.com), two healthcare companies (CSL and Cochlear) and an education services provider (Navitas).

The common factor in these businesses is minimal ongoing capital expenditure to run the company. Bringing up the rear are a range of capital heavy businesses that require both large amounts of initial capital to start the business and regular capital expenditure to maintain the quality of their assets and finance their ongoing activities. This sub-set includes a winemaker (Treasury), miners (Iluka and Alumina), a steelmaker (BlueScope) and a gain handler (Graincorp).

Return on Assets

Return on Assets (ROA) differs from ROE, as it measures the return a company makes on its total assets. This measure accounts for both the equity and the debt used to purchase the assets that generate a company’s profits.

This chart shows the top and bottom companies in the ASX ranked by ROA. Companies generating a high ROA are generally companies with no debt such as Magellan and Realestate.com or very low debt such as CSL and Carsales. Here the factor driving profits in internet and healthcare companies is generally a smart idea (online real estate listing replacing paper) or a piece of medical research, rather than tangible assets such as steel mills or airplanes bought with capital raised from both shareholders and lenders.

Similarly, fund managers (Magellan) enjoy significant operating leverage, as once the fixed cost of fund distribution, office rent and fund manager salaries are covered by a level of funds under management, each additional dollar of revenue is almost pure profit that requires minimal capital.

Alternatively, companies that have a low return on assets typically require expensive hard assets to generate profit and operate in industries where they are price takers. These assets range from mines (Iluka and Alumina), steel mills (BlueScope) and toll roads (Transurban).

Profit margin

Profit margin is calculated by dividing operating profits by revenues and measures the percentage of each dollar received by a company that results in profit to shareholders. Typically, low margin businesses operate in highly competitive mature industries. The absolute profit margin is not what analysts will look at, but rather the change from year to year, as a declining profit margin may indicate stress and could point to large future declines in profits.

The chart shows the highest profit margins are generated by companies that are monopolies (ASX), fund managers enjoying operating leverage (Magellan and Henderson) or infrastructure owners (Spark, Duet and SP Ausnet). Woodside enjoys a high profit margin, as once large offshore LNG trains are built, these assets have a low marginal cost of production per barrel of oil.

Low profit margin companies characteristically receive large revenues, but operate in intensely competitive industries such as petrol retailing (Caltex), engineering (Worley Parsons) and steel (Sims and BlueScope). Graincorp makes this list due to lower grain exports due to a relatively poor East Coast wheat harvest. Companies with low profit margins are obviously forced to concentrate closely on preventing their profit margins from slipping, as a small change in their margins is likely to have a significant impact on the profit available to be distributed to shareholders.

Whist the banks and the diversified miners generate large absolute profits and generate headlines often gasping at the amount, they are not actually amongst the most profitable large listed Australian companies in terms of profit margins and returns on assets. Westpac’s 35,241 employees produced a $7.8 billion profit in 2015, but this represented a ROE of 15.8% and a profit or net interest margin of only 2.11% on a loan book of $623 billion!

We approach the end of 2015 with our reporting season scorecard for the major banks as follows, with a Gold Star awarded for the best in each category.

Hugh Dive is Senior Portfolio Manager at Aurora Funds Management. This article is general information and does not address the personal circumstances of any individual.

 


 

Leave a Comment:

     

RELATED ARTICLES

Behind the headline profit numbers

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Welcome to Firstlinks Election Edition 458

At around 10.30pm on Saturday night, Scott Morrison called Anthony Albanese to concede defeat in the 2022 election. As voting continued the next day, it became likely that Labor would reach the magic number of 76 seats to form a majority government.   

  • 19 May 2022

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Welcome to Firstlinks Edition 454 with weekend update

Before the last Federal election, these pages were filled with policy discussions and articles generating hundreds of comments as Labor ran a large target agenda. We all know how that ended. Most Australians distrust government and media, and this campaign will be handouts, spin and personality attacks. Will Australia emerge more divided than ever?

  • 14 April 2022

Latest Updates

In praise of our unique democracy and its sausage

For all the shortcomings of our political campaigns, our election process is the best. We are blessed with honest administrators and procedures that we all trust to hand over power peacefully, with a big snag. 

Investment strategies

Is the investing landscape really different this time?

Many market analysts argue that the pandemic has changed everything but we must judge whether the circumstances are as drastic as billed. A quick review of four major events helps decide if this time is different.

Economy

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Retirement

When will I retire? Economic impact of an ageing population

About 39% of the labour force is aged over 45. Intergenerational reports highlight the challenges of an ageing population and the impacts on consumption patterns, dependencies, public finances and economic growth.

The real story behind the crypto crash

The recent sell-off in the crypto market and its trigger - the collapse of the Terra UST coin - has affected many institutions either holding or trading crypto assets, including crypto fund managers.

Investment strategies

Cash is the nightingale, the bird in the hand

The bird in the hand is worth two in the bush, and it's an apt metaphor for investment choices. In 2021, as investors hunted in the bush for decent returns, demand overwhelmed supply. Cash is the bird in the hand.

Strategy

Book review of 'Putin’s People' and his motivation for war

Author Catherine Belton argues Putin’s sole ambition is to hold onto power. Her book seeks to understand why Putin invaded Ukraine after he became isolated and out of touch with reality during the pandemic.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.