In this video, we're going to talk about measuring and analyzing profitability. This is probably the task that analysts spend the most time on when they look at a company's financial statements. How profitable was it and what are the underlying drivers of profitability? We're going to look at profitability in three different ways: in raw dollars, on a per share basis, and on a rate of return per dollar invested. There's pluses and minuses associated with each of these. So, let's start with the raw dollars. What was the net income for the firm or what were its profits? It turns out that of the three different ways you could think about profitability, raw dollars is actually the one that people pay the least attention to. And the reason is, it's very difficult to come up with a benchmark for what constitutes a good amount of net income. For example, suppose the firm reported income of $100,000. Is that good? Well, with no other information, it's hard to say. In part, it depends on what was invested to generate income of $100,000. If we'd invested a trillion dollars and only got a return of a $100,000 back, that's really not a very good return. We could have invested in something much safer, maybe even treasury bills, and gotten that much of a profit with that big an investment. On the other hand, if we'd only invested a $100,000 and got that big a return, that would be a fabulous rate of return, fabulous profitability. We probably wish we had invested more, if we could have kept up that profitability rate. So, the problem with income in dollars is that it mixes together the scale of the investment with the rate of return earned by the investment. And this is important because managers tend to have incentives to up the scale of the firm. They want to manage bigger firms, they want to build empires, those kinds of things, and if we look at raw dollars of profits, it's easy for them to show increasing profits simply because of the increased scale of the firm. To illustrate this, suppose we have a firm that starts with an investment of $100 and it earns a rate of return of 20 percent. Well, that brings its capital up to $120. They could pay out some of that as a dividend and if they did, they would have less than 120 going into the next period. But if they keep all of the money within the firm, they start with the capital base of 120 and you don't have to earn that higher rate of return on 120 to beat last year's profits of 20. In fact, with a 120-dollar capital base, if your rate of return drops to 18 percent, your profits are still 2,160 which is bigger than last year's 20. So, you could make the claim look we're doing better when in fact, you're doing worse with the assets that you've got. Shareholders often try to take steps to discourage managers from holding on to capital especially when they don't earn a very high rate of return on it and looking at performance measures other than raw dollars is one way to do that. So, a more commonly looked at measure of performance, instead of the raw earnings numbers, is the earnings per share. So, this is trying to say, how many dollars not in total the shareholders get, but does each shareholder get. So, we're going to divide earnings by how many shares there are outstanding for the firm. Now, if you actually look at an income statement, you can see the earnings per share number calculated for you near the bottom of the income statement. And in fact, you'll see two earnings per share numbers actually shown. One is basic earnings per share, that's earnings divided by how many shares are actually outstanding, and the other one is a more conservative measure. It's called diluted earnings per share. It divides not just by the shares that are out there now, but also by securities that could convert into shares. So, examples of these kinds of securities would include things like stock options or convertible bonds. Diluted earnings per share is trying to get at the idea that your piece of the pie could go down if more people become shareholders because they convert these existing securities here. And so, we're trying to give you some warning of that idea. Diluted earnings per share is never higher than basic earnings per share. Of these two, diluted earnings per share is the one that analysts and managers actually pay attention to. When you see analysts forecasts or management forecasts of earnings per share, they mean the diluted earnings per share number. Now, there's problems with interpreting diluted earnings per share or basic earnings per share if we're trying to look across firms, if we're trying to compare two firms, and this is because their share structure can be completely different and not necessarily reflect any differences in the real underlying economics. So, for example, suppose we have two firms with the exact same earnings, $100 say, and the exact same value of their total shares, $1,000. But one firm has chosen to split up their ownership structure into 50 shares worth 20, and the other one has a 100 shares worth 10. While earnings per share is going to be different for the two companies, but it's not the case that one company did better than the other company, it's just a function of the fact that the one company's got more shares. In addition, firms can undertake transactions to influence their share count which don't necessarily have any real economic substance and influence the earnings per share number that way as well. So, you have to be careful about interpreting earnings per share. And an alternative to this is not to divide earnings by shares, but to divide earnings by dollars of investment. So, this is what we want to turn to next. There are many kinds of return on investment type performance measures. We're going to focus on a very popular one, return on shareholders investment or ROE. This is calculated as net income, which is income to shareholders divided by the average balance of stockholders' equity in the firm, which is shareholders' investment. So, this is going to give us a measure of the rate of return that shareholders earn per dollar of their investment. This combines income statement information, net income, with balance sheet information, that's the stockholders' equity account. In principal, return on equity, is much easier to compare across companies. One thing you do have to be careful about, though, is companies with different amounts of risk, should earn different rates of return. It makes sense that the bigger the risk that shareholders face when they invest in one company, the higher expected rate of return they should be offered in order to compensate them for that risk. So, here's our profitability measures for our case firm, large, non-US, multinational company in the pharmaceutical industry. And as we can see as we go over time, all three measures go down: net income, basic diluted earnings per share, and our return on equity number. Note that the return on equity number is a function of both the income going down, but also, it depends on what's happening to the shareholders' equity. Shareholders' equity is actually going down as well. This is because the firm is buying back shares in 2xx2, and because they're paying out more dividends than their earnings are in the next two years. So we would expect earnings to go down just because the shareholder base is going down. And we're seeing earnings is going down by even more than that. That's why the ROE is going down so dramatically because income is falling faster than the share bases. Why? Well, that's what we want to do next. We want to try to figure out a framework where we can take the ROE numbers, and decompose them into their underlying drivers, come up with measures for those, and then help us answer the question, why has ROE gone down so dramatically? This framework is sometimes referred to as DuPont analysis because the DuPont Company was the first company that really started to do this in a big way a long time ago. This is an extremely useful tool. Many analysts describe this as the first thing that they do when they want to try to figure out what's going on within a company. So, DuPont analysis, is a framework where we're going to start with a return on equity or ROE and decompose it into some fundamental underlying drivers. This chart represents the path that we're going to go down, to try to decompose ROE into the drivers. As we'll see, this is a multiplicative relationship. So, all of these factors interrelate or interact with each other to determine the overall profitability. Some of these are ratios or terms that you might be a little bit familiar with, and what we're going to do is show how they all linked together. So, this is an overview of where we're headed. What we're going to do is try to build this up then so that we can see how ROE is being driven by these underlying factors. So let's start with the top part. We can rewrite ROE, Return on Equity, as the product of two terms. ROA, or Return on Assets, and something that we call Financial Leverage. Mathematically, we've written out the expression ROE is income divided by stockholders' equity, ROA is income divided by assets, and the financial leverage is assets divided by equity. We've got assets in the numerator of one expression and the denominator of the other, so that cancels when we multiply, which leaves return on equity which is what we started with. So we're just decomposing this algebraically into two terms, that have nice economic interpretations. So, in particular, what we're saying here is, you can decompose the firm's profitability as measured by ROE into two factors. One, the operating performance is a measure of how well the firm did with its assets. The other, financial leverage, is a measure of how well the firm arranged its capital structure. Both of those are important in determining the overall performance of the company. But now, we've got a measure on each one so we can see whether or not performance is declining because of a decline in one factor or the other factor. So, writing that out in a little bit more depth, we're decomposing profitability or ROE into an operating performance measure. How well did we do with our assets? We're calculating it using a measure called ROA, Return on Assets, net income divided by assets. And then we're going to interact that with the financial leverage factor, that is, how did the manager structure the financing of the assets? Remember, assets equals liabilities plus owners' equity. How much of it is liabilities? And how much of it is owners' equity? This is going to try to measure the extent to which the managers can leverage up, their investment in the firm with the investment by other people, in particular, the debt holder. A key thing here is the economic notion of leverage being an amplifier. Leverage is going to amplify good times and make them better for shareholders. But it's actually going to make worse bad times, and make them worse for shareholders. So leverage is an important indicator of risk because it amplifies both good times and bad times. Intuitively, the idea is leverage tries to take advantage of the fact that other people have invested money, and you might get some of that return. So, here's our ROE drivers for our case firm. So we've already calculated the ROE as a whole. And now, we're calculating the ROA and the leverage ratio as well. And we can see that ROA times leverage actually is the ROE numbers. But we can also now see what's causing ROE to go down, okay? And if we look at the numbers, it's actually the ROA that's going down. The leverage is in fact going up. So first of all, we note that ROE is bigger than ROA. That means that the firm is taking advantage of leverage. But the ROA going down is what's causing the ROE to go down. Managers are not using the assets as profitably as they were in the earlier years. And so, that's what's causing the firm's performance to go down. The leverage ratios are actually going up. We had noted this before that the liabilities are going up but the equity is going down. And if we actually look in detail at what line items within the liability sections are going up, it's mostly the line item, other long term payables. So, that's a pretty vague name. If we look in the footnotes, we can actually find out what that represents and it turns out that it's something called a contingent liability associated with payments that we're going to make to the shareholders of a firm that we just acquired. So what we've seen at this point is, ROE is going down and it's mostly attributable to ROA. We're going then continue this and dive deeper into ROA to figure out why that's going down.