“Why so glum? It’s friday afternoon for crying out loud” (A senior executive to his subordinate)
Subordinate: “See this pile of resumes? All applicants for that open role on our team. I’ll spend the best part of the weekend shortlisting this lot.”
Senior Exec: (picks up pile, splits into two. Tosses one half into the trash can)
Shocked Subordinate: “What about finding the best person for the role?!”
Senior Exec: “Who needs unlucky people on the team. Enjoy your weekend.”
Think of the pile as companies you could invest in. Sure you could comb through each one to find the absolute best. Or you could apply shortcuts to toss some into the metaphorical trash can. One such shortcut can be profitability.
Remember, when a great management goes up against a lousy business, the reputation of the business usually prevails. So why not make life easier by looking at the best and the least profitable industries.
Quick refresher on the three metrics:
Profitability is described by different accounting metrics, each one with its own merits and drawbacks.
EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) is useful when comparing companies within a sector where some participants might have made recent investments compared to others who been around a long time. It inflates profitability for companies that aggressively capitalise costs.
EBIT (Earnings before Interest and Taxes) ignores the composition of capital structure i.e. extent of Debt involved (like EBITDA). Useful in comparing across industries which might have different tax incentives
Net Profit, the final item on the Profit & Loss Statement takes out all costs and is the Earnings in Earnings per Share. It is also most amenable to be massaged to show desired trends with minor adjustments of various line items above it on the Profit & Loss Statement.
No one metric is sufficient to gauge true profitability, taken together, particularly when tracked over time, they give a sense of the depth of profit pools in various industries.
[Excerpt from Seth Klarman’s book, Margin of Safety at the bottom of this post beautifully explaining why Net Profit > EBIT > EBITDA as a valuation tool]
EBITDA Analysis obscures the difference between good and bad businesses
EBITDA, in addition to being a flawed measure of cash flow, also masks the relative importance of the several components of corporate cash flow. Pretax earnings and depreciation allowance comprise a company’s pretax cash flow; earnings are the return on the capital invested in a business, while depreciation is essentially a return of the capital invested in a business. To illustrate the confusion caused by EBITDA analysis, consider the example portrayed in exhibit 1.
Investors relying on EBITDA as their only analytical tool would value these two businesses equally. At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing. Although these businesses have identical EBITDA, they are clearly not equally valuable. Company X could be a service business that owns no depreciable assets. Company Y could be a manufacturing business in a competitive industry. Company Y must be prepared to reinvest its depreciation allowance (or possibly more, due to inflation) in order to replace its worn-out machinery. It has no free cash flow over time. Company X, by contrast, has no capital-spending requirements and thus has substantial cumulative free cash flow over time.
Anyone who purchased Company Y on a leveraged basis would be in trouble. To the extent that any of the annual $20 million in EBITDA were used to pay cash interest expense, there would be a shortage of funds for capital spending when plant and equipment needed to be replaced. Company Y would eventually go bankrupt, unable both to service its debt and maintain its business. Company X, by contrast, might be an attractive buyout candidate.
The shift of investor focus from after-tax earnings to EBIT and then to EBITDA masked important differences between businesses, leading to losses for many investors.
How the rankings were determined: Simplistically.
Aggregate [Profit Metric] in ₹ for the sector / Aggregate Sales for the sector
This implies the rankings are sales-weighted and give higher weight to larger companies by Sales in their respective sectors. The assumption being if two companies exist in a sector, one with 90% share and 10% profit, the other with 10% share and 50% profit, the larger company is more indicative of the dynamics of the industry than its smaller, niche rival.
Take a look at the ranks of most and least profitable industries last year
2019 Most Profitable Industries: Total Sales > 15,000 Crores
Yellow Shaded industries appear only twice in the list. Red shaded industries appear only once. Unshaded industries appear in all three lists.
2019 Most Profitable Industries: Total Sales between 3,000 and 15,000 Crores
2019 Least Profitable Industries: Total Sales > 15,000 Crores
2019 Least Profitable Industries: Total Sales between 3,000 and 15,000 Crores
Connect with me @CalmInvestor to engage.