Profitability – Normalised Return on Equity
In order to calculate the intrinsic value of a company’s stock we need to consider the profitability of that company.
Profitability versus Profit
It is important to understand that profitability is not the same as profit.
Profit is the amount of money the company makes each year. It is a measure of output.
Profitability takes into consideration the amount of capital (or equity) required to generate that profit. In other words, it measures the amount of input required to produce the output. This is known as return on equity (ROE). ROE is calculated by dividing the amount of profit by the shareholders’ equity employed. It is usually presented as a percentage and can be calculated as follows:
“Put simply, ROE is earnings as a percentage of shareholders’ equity in the business – and is a key measure of profitability.”
As an example, it makes a difference to a company’s value if a profit of $100,000 was generated from a capital base of $1 million or $10 million – that is, a ROE of either 10% or 1%.
At Clime, we ‘normalise’ the profitability to exclude any one off, non-recurring, adjustments to the bottom line and add back franking credits (a crucial element when investing in Australian shares). That way, our valuation is more appropriate.
Profitability can be viewed as:
- In a single year the measure of profitability of a company is the Normalised Return on Equity (NROE).
- Over several years the measure of profitability of a company is calculated as the Average NROE.
At Clime, we take an average of the last five years to calculate the Average NROE.
Once the real profitability of a company has been established, we are in a position to begin to identify what value we should be attributing to a company’s stock.
Our investment team, using the valuation tool StocksInValue, calculates the NROE as part of our valuation of a company and its shares.
By taking advantage of a realistic valuation and comparing it to the current market price, Clime’s clients, through our various products, have been able to make solid returns over the long haul, whilst minimising risk.
Read more about Value Investing