It’s not enough for a valuation expert to perform complex and accurate financial analyses; he must also be able to clearly and effectively communicate the results to a layperson. Unfortunately, while acronyms and abbreviations like “EBITDA,” “WACC,” and “CapEx” may be commonplace on valuation blogs, these terms thrown around like a gunslinger’s lead can leave our clients ducking for cover. This article is the first in a series aimed at demystifying the jargon so commonplace in the finance industry, yet so esoteric for the rest of the world. The terms selected for discussion in Part I all have a common thread, they are measurements of a company’s earnings.
The earnings generated by the operations of a company are often the means by which we judge the effectiveness of the company’s operations. This directly impacts value as earnings are a key driver in both the Income and Market Approaches to valuation. Many of the earnings metrics discussed in this article can be found through analysis of the line items on a company’s income statement (also frequently referred to as a profit & loss statement, or just P&L).
As our repeat readers might know, we like to include illustrative examples and case studies in our articles. For purposes of our discussion on earnings metrics, we will be referring to Susie’s Sunshine Lemonade (“Susie’s”), a successful chain of high-tech, kid-operated, and parent-sanctioned lemonade stands.
The P&L for Susie’s most current fiscal year is shown on the following page and is referenced throughout.
Revenue (Sales, or Gross Receipts)
Revenue (also commonly called sales, gross receipts, or just “the top line,” because of its position at the top of the income statement) is the most basic earnings metric. Revenue is simply the total value received by a company in exchange for the goods or services that company sells. In our example, last year Susie’s sold 4.2 million cups of lemonade at $0.50 per glass, thus “grossing” (the verb for generating revenue) $2.1 million. Therefore, in the financial vernacular, an expert might say that Susie’s is a $2 million company.
The reason revenue is frequently utilized in talking about the size of a company is because it is a pure indication of the value of goods or services a particular company provided in a given time period. As such, when you hear experts say, “The firm grew by 15% last year,” they are probably referring to revenue growth.
A significant limitation with the revenue metric, however, is that revenue is not impacted by the costs a company incurs to generate that revenue. A concrete example most people have experienced is a busy restaurant. You go out to dinner with friends to a posh restaurant and the line is out the door. Someone comments, “This place is making a killing! The owner’s gotta be making money hand over fist!” A year later the restaurant is closed and there’s an article in the local paper about the owner filing for bankruptcy. What happened? It was probably the difference between revenue and one of the other earnings metrics discussed later in this article. The restaurant may have been grossing significant sales, but its expenses (wait staff, imported foods, high rents, and payments on the debt the owner took out to build the place) exceeded the money the throngs of customers were paying him for their food.
Despite the inherent limitations of revenue as a metric, an analysis of the revenues generated by a company can allow an expert to understand how a company makes its money, what historical (and perhaps, future) trends the company has experienced, and how that company fits into a broader market of similar businesses.
Gross Profit (Gross Margin)
The next earnings metric on an income statement is gross profit (aka gross margin). Gross profit is measured as total revenue less direct expenses attributable to the generation of that revenue. For example, Susie’s direct expenses (also referred to as “costs of goods sold” or “cost of sales”) may include the cost of lemons, sugar, and other materials. Additionally, direct expenses could include the salaries and wages of the employees directly responsible for the production and sale of the lemonade. If Susie’s revenue totaled $2.1 million, and direct expenses were $1.4 million ($800,000 of materials and $600,000 of direct labor), the company’s gross profit would equal $700,000 (lines 4-7 on the P&L). The company’s gross profit percentage is derived simply by dividing gross profit by total revenues. In our example, Susie’s gross profit percentage is 33.3%, or $700,000 divided by $2.1 million. Conceptually, Susie’s gross profit percentage of 33.3% can be interpreted as: “for every dollar of lemonade sales, there are 33.3 cents left over after paying expenses directly related to creating those sales.”
One of the reasons financial analysts review the gross profit percentage is to better understand some of a company’s direct variable expenses (expenses that fluctuate as sales levels increase or decrease). Many of these expenses are not easily controlled by the company. For example, Susie’s cannot determine the price of its raw inputs like lemons or sugar, nor can it determine the going rate for wages. Because of this, large fluctuations in a company’s gross profit percentage should be investigated. Several common reasons for shifts in gross profit percentage are:
1I Changes in market prices – This could include the market prices of the company’s goods or services (e.g., the lemonade stand market is flooded with new proprietors who are undercutting Susie’s price), or the market prices of the materials and labor Susie’s purchases to make and sell her lemonade (e.g., a drought causes a lemon shortage and Susie’s costs to buy lemons spike).
2I Changes in product mix – If a company sells multiple products or services that each have their own unique cost structure, fluctuations in how much of each product or service that company is selling could impact the gross profit percentage. For example, if Susie’s also started selling “hard” lemonade to adults, the profit margins on this new product might be significantly greater than on regular lemonade. Therefore, as Susie’s sells more hard lemonade vis-à-vis regular lemonade, the gross margin percentage will increase.
3I Reclassification of costs – Frequently, when a business hires new accountants, certain expenses are re-categorized. For example, if the chief sales officer’s salary was previously classified as a cost of goods sold, but the new accountant moves it “down the income statement” into administrative expenses, the gross margin percentage would increase on paper, but would not impact the effective profitability of the entire company.
4I Other reasons – Financial statement manipulations, one-time expenses, fundamental shifts in operations, and many other, less common reasons could also impact a company’s gross profit percentage.
The important thing to keep in mind is if a client tells you, “My gross margin is way down this year,” your next question should be, “Why?”
Operating Profit (Operating Income)
Mathematically, operating profit (or operating income) is calculated by subtracting all administrative and overhead expenses from gross profit. For our example (lines 8-11), these expenses could include the salaries and benefits of any administrative or management level employees; rental expenses, advertising and marketing expenses, depreciation related to the company’s property, plant, and equipment assets, and other general and administrative expenses. If Susie’s gross profit is $700,000, and total administrative and overhead expenses are $300,000, then the company’s operating profit is $400,000. The company’s operating profit percentage is calculated by dividing its operating profit of $400,000 by total revenues of $2.1 million, or approximately 19.0%.
“Operating” is the key word in operating profit. This level of earnings includes deductions from revenues for all expenses pertaining to the operations of the business. In the case of Susie’s, all direct expenses (lemons, sugar, etc.), as well as indirect and overhead expenses (management compensation, corporate offices, etc.), are accounted for in the calculation of operating profit.
Net income, commonly referred to as “the bottom line,” or simply “earnings,” is the accounting income reported on a company’s income statement. It takes into account all reported revenues and expenses. Unlike operating profit, net income includes the income and expenses that are generated from all sources, including sources outside the business’s regular operations. In the case of Susie’s (lines 12-16), other income and expenses include proceeds from a one-time insurance claim, a loss recognized when marketable securities were sold, interest and dividend income from investments, and interest expense owed on the company’s interest-bearing debt. These items are not part of the core business operations, but they nevertheless impact the company’s bottom line of $255,000 (line 19).
It is important to note that net income is an accounting metric and may not accurately measure the true economic earnings or cash flow that a company generates. For example, many companies keep accrual-basis accounting records whereby revenue is recognized when it is earned, not necessarily when payment is received. These kinds of transactions give rise to “accounts receivable.” In some industries—healthcare is a good example—receivables may not be collected for several weeks or even months after the company has reported generating the revenue. Additionally, the company’s net income may include deductions for non-cash expenses like depreciation or amortization. Finally, a company’s net income does not include deductions for cash expenditures on fixed assets. In order to truly understand the amount of economic income a company generates over a given period of time, other earnings metrics must be analyzed.
Despite the inherent limitations of net income, it is still one of the most commonly used terms to describe earnings. When you hear someone talking about “bottom-line earnings,” keep in mind it may not be the bottom line in the discussion.
EBIT, or earnings before interest and taxes (most often pronounced “E-bit”), is calculated by adding back (removing the effect of) interest expense and tax expense to net income.
The reason EBIT is used in the place of net income on certain circumstances is because it may provide a better metric to compare the level of earnings among companies. By removing interest expense, we’re better able to compare companies with different capital structures (i.e., companies similar in operations, but that have differing levels of debt). For instance, if we’re comparing two companies, and one has much more debt than the other, and in turn has much greater interest expense, the company with less debt would have a much higher net income, all else equal. Tax expense is removed because effective tax rates can be radically different among companies, even in the same industry, due to the flexibility of accounting practices.
EBITDA, or earnings before interest, taxes, depreciation, and amortization (most often pronounced, “E-bit-dah”), is calculated by adding depreciation and amortization expense to EBIT. Although EBITDA is not a financial metric recognized in generally accepted accounting principles, it is simple to calculate and is widely used by analysts when assessing the earnings performance of companies. EBITDA is intended to allow a comparison of profitability between different companies by canceling the effects of:
1I Interest payments from different forms of financing (by excluding interest payments)
2I Political jurisdictions (by excluding taxes)
3I Collections of fixed assets (by excluding depreciation)
4I Different takeover/acquisition histories (by excluding amortization of acquired intangible assets)
A common misconception, however, is that EBITDA is equivalent to cash flow. As will be further discussed below, there are several key distinctions between EBITDA and the measures of cash flow directly utilized in the Income Approach to valuation.
EBITDAOC, or earnings before interest, taxes, depreciation, amortization, and owners’ compensation (pronounced, “E-bit-dah-ock”), is a less common metric that is used to compare levels of earnings among smaller companies that may differ in the compensation of their owners. For example, the owner or owners of small companies frequently do not distinguish between cash they receive from the business as wages versus cash they receive as non-taxed distributions (if they own an S corporation or LLC). From the owners’ perspective, either way it’s cash in their pockets. Frequently the decision of how to extract their earnings from a company has nothing to do with high finance, but rather comes down to whichever way their accountant tells them will lead to the lowest tax bill. When analyzing and comparing these companies, EBITDAOC, while difficult to say and type, can be an important metric that eliminates the individual differences between how owners pull their money out of small businesses.
Free Cash Flow to Invested Capital
Free Cash Flow to invested capital, also known as Free Cash Flow to Firm (“FCFF”), is a commonly used metric that tells how much cash flow is available to pay stockholders and debt holders (the collective investors in a business), after consideration of the cash reinvestment required to support the company’s continued operations and future growth. In order to understand how FCFF is calculated, there are two terms that must be understood:
1I Working capital – While a full discussion is beyond the scope of this article, working capital is broadly defined as a company’s current assets minus any current liabilities. Current assets typically include items like accounts receivable, prepaid expenses, inventory, etc. Current liabilities typically include items like accounts payable and other accrued expenses. As a company grows, there may be a lag between when sales are generated and when dollars are actually collected. In the meantime, the company’s employees, vendors, and other creditors are still demanding payment for the goods and services they provided to the company. This differential is called working capital growth and represents a cash investment necessary to fund a company’s growth. Therefore, cash invested in working capital growth is not available to distribute to any debtors or stockholders.
2I Capital expenditure – This term refers to the funds spent on long-term property, plant, and equipment (aka hard or fixed assets) that will be used and depreciated over a period of time greater than one year. The up-front cash expenditures for investments in these fixed assets are generally not found on the income statement; rather, they are recorded on the balance sheet and cash flow statement. Over a period of years, these assets are depreciated for accounting purposes, and expenses totaling the cash expended are eventually recognized on the income statement. Since expenditures on fixed assets are necessary to maintain a company’s operations, but aren’t reflected as they are incurred on the income statement, an adjustment must be made to arrive at FCFF.
To calculate FCFF, we first calculate debt-free net income, or net income before the effect of interest payments to a business’s creditors. By subtracting income taxes calculated based on EBIT, we arrive at debt-free net income. From there, we add back depreciation and amortization, which are non-cash relics of prior transactions, and subtract capital expenditures and additions to working capital. This leaves us with cash that is available to distribute to debt and equity investors without impairing the operations or growth expectations of the business.
FCFF can be a direct input in the Income Approach to valuation and is a preferred metric to utilize in the Discounted Cash Flow Method and Capitalization of Cash Flows Method when valuing the total invested capital, or enterprise value, of a company.
Free Cash Flow to Equity
Free Cash Flow to Equity (“FCFE”) stems from the same principle as FCFF; the difference is that FCFE represents the amount of cash flow available to equity holders after debt investors have received their return in the form of both interest and principal repayments. This means that an analyst must deduct interest expense
and any decrease in debt borrowings (principal). To arrive at FCFE, we start with net income, add back depreciation and amortization, subtract capital expenditures and additions to working capital, and subtract reductions (or add additional borrowings) to interest-bearing debt.
FCFE can be a direct input in the Income Approach to valuation and is a preferred metric to utilize in the Discounted Cash Flow Method and Capitalization of Cash Flows Method when directly valuing operating equity of a company.
This concludes our discussion of the common earnings metrics used by experts to describe company performance. The next time an expert gazes into his spreadsheet and tells you, “this company earned $10 million last year,” perhaps you can surprise him by responding: “by ‘earned’, do you mean in revenue, gross profit, operating income, net income, EBIT, EBITDA, EBITDAOC, or some level of free cash flow?”
Tune in next time for more jargon demystified with Part II, The Income Approach!