Profit (or earnings) is the amount a business earns over all of its expenses; including taxes and what it pays to the managers. Profit ultimately belongs to the company’s owners, such as stockholders.
Usually P/E is what we use to determine a profit percentage. For instance, if P (price) is 100 and E (earnings) is 20, our P/E is 5. 5 is actually the inverse of profit to stock price, which in this case is 20% or .2. The smaller the P/E number the more a company makes in profit per share.
Why We Can’t Just Depend On Profit To Evaluate A Company
Profit is a very important number in evaluating a company, but we don’t usually evaluate a company on profit alone. Mainly because things can and do change. In the case where our business doesn’t generate enough profit, we want the business to survive long enough to resolve the problem. If the business has loss after loss for years, it will run out of cash and have to declare bankruptcy. But if instead then can resolve their problem(s) and return to profit, the business can be viable once again. Here are some things we can look at to see if they have a chance to resolve a change in business before they run out of cash:
Current Ratio or Cash Position: Current Ratio shows us how much cash we have to a year’s current expenses. The bigger the number, the more cash the company has. Too big a number and the company really should put the cash to work or return it to the shareholders. A number between 1 and 2 is the best. A startup may need more cash on hand. You can also look at the balance sheet to see how much cash the business has on hand and compare it to the current liabilities.
Debt: Debt is often called leverage because it will supercharge either profits or losses. I prefer a company has no debt but you can justify debt in several ways, such as if the business has real estate or heavy equipment, or if the interest rate of the debt is super low.
Profit is also a point in time profit and it can go up or down depending on growth. Growth is the amount or percentage that revenue is changing from year to year. More growth probably means that the company is more valuable than it’s profit.
Growth is usually talked about in revenue percentage growth. In order to get to yearly growth, you must subtract out expense which you can derive from the various margins. You could also apply the revenue percentage against profit, which will usually be lower than what the profit gain would be because as a business scales up expenses don’t scale up as fast as its revenue. (profit = revenue – expenses)
Now you can value a company in a lot of creative ways. For instance, you can put value on an experienced manager that has brought companies back from the dead before. You can value the product or the moat a company has. You can value an unprofitable company that has incredible growth.
One thing you cannot do is come up with specific information about a company that the market does not have, then buy or sell based on that. That is called insider trading. But often public information that is available to everyone is useful because most people don’t pay enough attention to them. Of these, profit is arguably the most important one.