Why investors should check this before buying any shares

The Motley Fool

Perhaps the biggest catalyst for any share price is profit growth. History shows that companies which are able to deliver consistently high growth in profitability tend to be rewarded by investors with higher valuations. As such, many investors focus on forecasting profitability in order to assess the potential upside on offer in the long run.

However, the problem is that 'profit' comes in different shapes and sizes. Therefore, it can be worth spending time working out exactly how profitable a business is today, before contemplating how profitable it might be in future.

Differing figures

According to Warren Buffett's investment partner, Charlie Munger, EBITDA (earnings before interest, tax, depreciation and amortisation) is not a useful measure of a company's profitability. One reason for this could be that items such as interest, taxes, depreciation and amortisation must be deducted from a company's income before arriving at net profit in every year of its operation. In other words, they are continuing costs and so perhaps should be deducted from revenue before arriving at a figure which truly represents the difference between a company's income and expenditure within a given year.

Of course, EBITDA is just one example of a number of different profit measures. For example, there is gross profit, operating profit, EBITA, profit before tax and many others. Investors should therefore ensure that when they are comparing two or more different companies they focus on comparing like-for-like measures of profitability.

Further changes

Of course, even if companies use the same measure of profitability, there can still be some differences in terms of what is included and what is not. Some companies will offer earnings which include the effect of currency adjustments (reported earnings), while others will exclude the effect of foreign exchange rate fluctuations.

Similarly, some companies will offer underlying earnings figures which deduct items that are not expected to occur on an ongoing basis. Such costs could include restructuring charges, for example. While they provide a guide as to the underlying performance of a business, which costs to include or exclude can sometimes be subjective.

Meanwhile, when earnings are produced on a per share basis, there will often be 'basic' and 'diluted' earnings. Some companies report one, others focus on the other measure. Although there is often little difference between the two, it is prudent to check this when making an investment-related decision.

Looking ahead

It seems likely that the wide range of profitability measures available is not going to decrease in the near term. Therefore, it may be prudent for investors to check they are using their preferred measure before buying one company over another, and that the methodology among different companies is comparable.

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