Businessman Investor

Touching base with the rational business psyche of stock market investors

Wednesday, November 26, 2014

Core Business Profitability and Its Mathematical Derivation

Profitability of the Company's Core Business Operations.
As businessmen investors, we would have to filter and qualify
general corporate profitability and be able to see through
the company's main core operations.
Our initial focus: EBITDA (Earnings before Interest, Taxes, Depreciation & Amortization). I would have to be honest that even I have been a cold skeptic of this metric in the early stages of my education in investing, but I have come to realize it recently that it is actually useful for purposes of observing Core Business Profitability. It filters the distortions of the Interest, Taxes, Depreciation & Amortization (D&A) portion and primarily focuses on innocent earnings derived from Working Capital's turnover activity.

Note: We would have to qualify "Earnings" as only those earnings derived from business operations and exclude Other Income which are derived from Non-core Business InvestmentsWorking Capital Turnover, on the other hand, would also have to be derived using Operating Expenses before D&A to be more meaningful since, as already explained, Working Capital has nothing to do with covering D&A.

Using this rationale, let's observe how this impacts our derivation of Core Business Profitability:

EBITDA / Opex before D&A = Mark-up

Opex before D&A / Working Capital = Working Capital Turnover

Mark-up x Working Capital Turnover = Working Capital Turnover Profitability

As earlier discussed, the impact of Working Capital can only go insofar as to how much it weighs against overall Operating Assets:

Working Capital / Operating Assets = Working Capital Weight

At this early, innocent stage, we can only observe how well working capital is contributing to business profitability given its scale relative to overall operating assets. But as some of you would argue, D&A are "real" business expenses, and have to be factored in when assessing profitability. I don't disagree. And that's what we will be doing now.

The diminishing effect of D&A can be expressed as a ratio of Capex Assets:

Depreciation & Amortization / Capex Assets = Depreciation Rate

The impact of this Depreciation Rate, similar to Working Capital Turnover Profitability, can only be so far as to its weight against overall Operating Assets:

Capex Assets / Operating Assets = Capex Weight


(Working Capital Turnover Profitability x Working Capital Weight) minus (Depreciation Rate x Capex Weight) equals Core Business Profitability

or as expressed mathematically:
EBIT / Operating Assets


Core Business Profitability = EBIT / Operating Assets

Core Business Profitability, as we have defined now, excludes the distortions of Interest and Taxes. Again, Interest is not a cost of fundamental business operations, but a cost of financial borrowing; what we are after is profitability regardless of financial structure. Taxes, on the other hand, is not subjected towards earnings coming from the core business operations alone (i.e. EBIT, as we have mathematically derived), but all corporate income. It should also thus be excluded. Continue to Part 3: The Cost of Borrowing and Its Impact Against Corporate Profitability

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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