Definition of Profitability

Profitability determines whether a business stays in business. In this

lesson, you'll learn about profitability and different ways to analyze it. A
short quiz follows the lesson.
Profitability is the ability of a business to earn a profit. A profit is what is
left of the revenue a business generates after it pays all expenses directly
related to the generation of the revenue, such as producing a product, and
other expenses related to the conduct of the business activities.
There are many different ways for you to analyze profitability. This lesson
will focus on profitability ratios, which are a measure of the business'
ability to generate revenue compared to the amount of expenses it incurs.
Let's look at a few of the primary analytical approaches.

Outstanding shares
Shares Outstanding is included in the market capitalization formula
(outstanding shares multiplied by current share price) and earnings per
share formula (EPS calculated as outstanding shares divided by earnings),
two major measures of a company's value and performance used by
investors.

Shares outstanding refers to all shares currently owned by stockholders,

company officials, and investors in the public domain, but does not include
shares repurchased by a company.

HOW IT WORKS (EXAMPLE):

Shares outstanding is also referred to as outstanding shares, or issued

shares.

Shares that are outstanding include stock owned by the firm's shareholders

and owners. Shares outstanding does not include treasury stock, which are
stock shares that are repurchased by the company. It also does not include
unissued shares.
The number of shares outstanding is listed on a company's balance
sheet as "Capital Stock" and is reported on the company's quarterly filings
with the US Securities and Exchange Commission. The number of shares
outstanding can also be found in the capital section of a company's annual
report.

Market Capitalization
Market capitalization refers to the total dollar market value of a company's
outstanding shares. Commonly referred to as "market cap," it is calculated
by multiplying a company's shares outstanding by the current market price
of one share. The investment community uses this figure to determine a
company's size, as opposed to using sales or total asset figures.

Using market capitalization to show the size of a company is important

because company size is a basic determinant of various characteristics in
which investors are interested, including risk. It is also easy to calculate. A
company with 20 million shares selling at $100 a share would have a
market cap of $2 billion.

Given its simplicity and effectiveness for risk assessment, it can be a

helpful metric in determining which stocks you are interested in, and how to
diversify your portfolio with companies of different sizes.
Although it is used often to describe a company, market cap does not
measure the equity value of a company. Only a thorough analysis of a
company's fundamentals can do that. It is inadequate to value a company
because the market price on which it is based does not necessarily reflect
how much a piece of the business is worth. Shares are often over-
or undervalued by the market, meaning the market price determines only
how much the market is willing to pay for its shares. 

Although it measures the cost of buying all of a company's shares,

the market cap does not determine the amount the company would
cost to acquire in a merger transaction. A better method of calculating
the price of acquiring a business outright is the enterprise value.
Price-Earnings Ratio - P/E Ratio
The price-earnings ratio (P/E ratio) is the ratio for valuing a company that
measures its current share price relative to its per-share earnings. The
price-earnings ratio is also sometimes known as the price multiple or the
earnings multiple. 

The P/E ratio can be calculated as: Market Value per Share / Earnings
per Share

In essence, the price-earnings ratio indicates the dollar amount an investor

can expect to invest in a company in order to receive one dollar of that
company’s earnings. This is why the P/E is sometimes referred to as the
price multiple because it shows how much investors are willing to pay per
dollar of earnings. If a company were currently trading at a multiple (P/E) of
20, the interpretation is that an investor is willing to pay $20 for $1 of
current earnings.

To calculate the P/E ratio, the earnings per share (EPS) must be known.

EPS is most often derived from the last four quarters. This form of the
price-earnings ratio is called trailing P/E, which may be calculated by
subtracting a company’s share value at the beginning of the 12-month
period from its value at the period’s end, adjusting for stock splits if there
have been any. Sometimes, price-earnings can also be taken from
analysts’ estimates of earnings expected during the next four quarters. This
form of price-earnings is called a projected or forward P/E. A third, less
common variation uses the sum of the last two actual quarters and the
estimates of the next two quarters.

Enterprise value represents the entire economic value of a company.

More specifically, it is a measure of the theoretical takeover price that an
investor would have to pay in order to acquire a particular firm.

HOW IT WORKS (EXAMPLE):

Enterprise value is calculated as follows:

Market Capitalization + Total Debt - Cash = Enterprise Value

Some analysts adjust the debt portion of this formula to include preferred
stock; they may also adjust the cash portion of the formula to include
various cash equivalents such as current accounts
receivable and liquid inventory.

For example, let's assume Company XYZ has the following characteristics:

Shares Outstanding: 1,000,000

Current Share Price:  $5
Total Debt:  $1,000,000
Total Cash:  $500,000

Based on the formula above, we can calculate Company XYZ's enterprise

value as follows:

($1,000,000 x $5) + $1,000,000 - $500,000 = $5,500,000

'Enterprise Value (EV)'

The Enterprise Value, or EV for short, is a measure of a company's total
value, often used as a more comprehensive alternative to equity market
capitalization. Enterprise value is calculated as the market
capitalization plus debt, minority interest and preferred shares, minus total
cash and cash equivalents.

EV = market value of common stock + market value of preferred equity +

market value of debt + minority interest - cash and investments.

Often times, the minority interest and preferred equity is effectively zero,

although this need not be the case.

Enterprise value represents the entire economic value of a company.

More specifically, it is a measure of the theoretical takeover price that an
investor would have to pay in order to acquire a particular firm.

HOW IT WORKS (EXAMPLE):

Enterprise value is calculated as follows:

Market Capitalization + Total Debt - Cash = Enterprise Value

Some analysts adjust the debt portion of this formula to include preferred

stock; they may also adjust the cash portion of the formula to include
various cash equivalents such as current accounts
receivable and liquid inventory.

For example, let's assume Company XYZ has the following characteristics:

Shares Outstanding: 1,000,000

Current Share Price:  $5
Total Debt:  $1,000,000
Total Cash:  $500,000

Based on the formula above, we can calculate Company XYZ's enterprise

value as follows:

($1,000,000 x $5) + $1,000,000 - $500,000 = $5,500,000

Enterprise-Value-To-Sales - EV/Sales'
Enterprise-value-to-sales is a valuation measure that compares
the enterprise value (EV) of a company to the company's sales. EV-to-
sales gives investors a quantifiable metric of how much it costs to purchase
the company's sales. This measure is an expansion of the price-to-sales
(P/S) valuation, which uses market capitalization instead of enterprise
value.

WHAT DO WE MEAN BY ENTERPRISE VALUE TO SALES RATIO?

EV / Sales is an interesting ratio. It takes into account the enterprise value

and then the enterprise value is being compared with the sales of the
company. Now why should we calculate EV / Sales ratio? By calculating
EV / Sales Ratio, we get an idea how much it costs to investors relative to
per unit sales.
From investors point of view, there are two interpretations that are most
important –

 If EV / Sales is higher, then it is considered that the company is

costlier and it’s not a good bet for investors to invest into because
they won’t be getting any immediate benefit out of this investment.

 If EV / Sales is lower, then it is considered to be a great investment

opportunity for investors; because when EV / Sales is lower, it is
perceived as undervalued and then if the investors invest, they would
get good benefit out of it.

So if you are an investor and thinking of investing into a company; but don’t
know whether it’s a good bet or not, calculate Enterprise Value to Sales
ratio and you would know! If it’s higher, stay away from investment; and if
it’s lower, go ahead and invest into the company (subject to the other ratios
because as an investor you shouldn’t take any decision on the basis of only
one ratio).

Cash Flow'
Cash flow is the net amount of cash and cash-equivalents being transferred
into and out of a business. At the most fundamental level, a company’s
ability to create value for shareholders is determined by its ability to
generate positive cash flows, or more specifically, maximize long-term free
cash flow.

What is the Cash Flow Statement?

A Cash Flow Statement (also called the Statement of Cash Flows) shows
how much cash is generated and used during a given time period. It is one
of the main financial statements analysts use in building a three statement
model. The main categories found in a cash flow statement are the (1)
operating activities, (2) investing activities and (3) financing activities of a
company and are organized respectively as mentioned.  The total cash
provided from or used by each of the three activities will be summed to
arrive at the total change in cash for the period, and then combined with the
opening cash balance to arrive at the cash flow statement’s bottom line,
the closing cash balance.