Profitability and Return on Investment

When you have completed this chapter you will understand:

the importance of profits to a business;

the usefulness of the various profitability ratios that have been developed;

that return on investment ratios have been developed that enable investors to assess their return;

the importance, and limitations, of earnings per share (EPS) as a measure of performance;

the nature and role of dividends;

the increasing importance of share buybacks;

the need to consider profitability and return on investment ratios in an overall context.

Next and M&S Shares go head to Head, by Mark Atherton

This summer Next achieved a historic milestone as it overtook fellow retailer M&S to post pre-tax profits of £695 million, compared with M&S’s £623 million. It was dramatic confirmation of a trend that has been developing for some time, with Next’s profits growing steadily from year to year while M&S’s have barely increased.

However, those thinking of investing in either company need to look at more than simple profit figures. The amount of cash the companies generate, the level of dividends they pay and the valuations the market places upon them are all elements that need to be considered before private investors hazard a penny of their hard-earned cash.

Here, with the help of Stockopedia, the online financial analysis tool, Times Money explains some of the key terms and examines how the two high street giants stack up against each other. Size

This can be measured in different ways. One is through annual turnover, or the amount of money spent in a company’s stores in a single year. The other is by market capitalisation, or the overall value placed on the company’s shares by the stock market.

M&S has much bigger turnover than Next, with revenues of £10.3 billion against Next’s £3.7 billion. Yet Next, on a much smaller turnover, has produced bigger pre-tax profits than its rival. Next’s ability to convert more of the money it receives into profits has also had a positive impact on its overall stock market value, which now stands at £10.6 billion, compared with £7.05 billion for M&S.

Profits

… Net post-tax profits at M&S have risen only modestly, from £508 million in 2008–09 to £524.8 million in 2013–14 – an annual growth rate of just 0.7 per cent. In contrast, Next’s profits have soared, from £302.4 million in 2008–09 to £553.2 million this year, reflecting a much healthier growth rate of 12.8 per cent.

Next has achieved this impressive performance by squeezing more profit out of each pound invested in the company. One way of measuring this is to look at the two retailers’ operating margins. This is a measure of how much of each pound of revenue is left after the cost of goods and operating expenses have been deducted. Next’s operating margin was 19.3 per cent, against 6.7 per cent for M&S. This measure demonstrates very clearly how Next is getting a bigger bang for every buck than M&S.

Ed Croft, chief executive of Stockopedia, said: “It is plain from the figures that Next has been a much more profitable business over the past five years. What’s especially notable is the strong growth in operating margins and profitability at Next versus declining margins and profitability at M&S.”

Cashflow

A key indicator of company quality is the level of free cash-flow. This is the money available to a company after it has spent what is required to run its business. Free cash flow can be used to fund future growth, pay off debts or be distributed to shareholders as dividends or share buybacks. Mr Croft says the clear winner here is Next, which has generated 13.6p in free cash flow for every £1 in sales versus only 4.7p for Marks & Spencer.

Dividends

Next is currently paying an annual dividend equivalent to 1.87 per cent of the current share price. M&S is offering a somewhat higher dividend yield of 3.94 per cent. However the other side of the coin is that Next has been growing its dividend at a faster rate than M&S. Over the past three years dividend per share growth has averaged 18.3 per cent on an annualised basis at Next, compared with 2.6 per cent a year at M&S.

This faster rate of dividend growth, coupled with a policy decision to distribute more of its earnings as dividends, means Next’s forecast yield for the current financial year is a much higher at 4.67 per cent, compared with 4.11 per cent for M&S.

Valuations

A stock may look attractive but it’s only worth buying if the price is right. The key measure of share valuation is known as the price/earnings ratio and represents the company’s share price divided by its earnings per share.

When investors are enthusiastic buyers of a company this pushes up the share price and also the price/earnings ratio. When the p/e ratio is high, shares are described as being on an expensive valuation; when low they are categorised as cheap. Next’s p/e ratio is 18.9, while M&S is on 12.9, so M&S is currently on a cheaper valuation than Next.

Share price growth

Over the past five years the M&S share price has risen by 25 per cent. The Next share price has gone up by 319 per cent. So investors in Next have seen the value of their shares grow by more than ten times as much as those who took a stake in M&S.

Mr Croft said: “When you look at the valuations put on the two companies, Next is more expensive for a reason. It is on a high valuation because the people running the company have driven it to record levels of profitability in recent years.

“Growth investors have proved ready to pay a higher price for that superior earnings growth – and may well continue to do so. Meanwhile contrarian and value-driven investors might be willing to invest in M&S as a turnaround situation.”

(The Times, 20 August 2014)