Profit Labels
What is the difference between "gross profit margin" and "markup"?
Tom C. -- Statesville, N.C.
As the folks at Enron and WorldCom demonstrated, these terms can mean pretty much whatever you want them to mean.
Subtle differences in accounting practices used to be reserved for industries that had legitimate reasons for doing things differently. A bank, and airline and a software company keep their books in slightly different ways because of the nature of how they make their money. But the underlying concepts are the same.
"Gross profit margin," for example, refers to a company's profit as a percentage of its total revenues. But the devil is in the details. What expenses are deducted before you get to "profit"? How do you book revenues? Without a national accounting oversight board -- with teeth -- companies have been free to massage these numbers pretty much as they see fit.
"Markup" is more informal. It's usually used to refer to the difference between, say, a wholesale and retail price. If you manufacture office chairs, sell them to dealers for $180 each and they sell them for $200, that's a $20 markup.
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Goodwill Hunting
From time to time I see the term “goodwill” in reports. What is this? It seems to be whatever the CEO wants it to be to make the books balance.
Michael B.
That’s not a bad definition. Here’s a more “official” one: goodwill represents (roughly) the market value of a company over and above the net worth of all of its hard assets minus its liabilities. That “intangible” value is supposed to come from things like a strong brand name, a lucrative patent, a uniquely strong market position, the outstanding productivity of its employees, etc. Those are all reasons investors pay more for a stock than what they’d get if the company were liquidated and the proceeds distributed to shareholders.
So goodwill is basically a fudge factor: while a company is usually “worth” more than its tangible assets (like real estate, equipment, investments, etc.) minus what it owes — the exact reasons can be tough to nail down. In order to account for that “extra worth” - and make the books balance — accountants came up with a catchall label in the assets column called “goodwill.” Over time, that fudge factor also came to be used to represent the premium paid in a takeover — the extra money paid by a company beyond what stock market investors said the target company was worth.
Last year, the Financial Accounting Standards Board, the accounting industry’s rule makers, finally decided that the use of goodwill had gotten out of hand. The board ordered companies to “test” the value of goodwill every year, and “mark it down” if they could no longer justify it. That’s why a company like AOL Time Warner, which merged in at the peak of the dot-com bubble when AOL’s stock was hyperinflated, recently took a charge of over $50 billion. The charge was really an admission that the company’s accountants had been playing with funny money all along.
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I have noticed the term “diluted share” used more frequently in financial reports. What is a diluted share and how did this term evolve.
Lloyd J.
Companies have taken a lot of flak recently for watering down their financial reporting, but in this case reporting on dilution means giving you more information — not less.
In this context, “dilution” refers to the effect of adding more shares to the pool of stock that is already trading in the open market. For example, if you own stock in a company with 1 million shares trading at $10 each, and the company decides to issue another 1 million shares, you’re holdings would be “diluted” by those new shares. Since the company hasn’t done anything to increase its value, the stock would drop to $5. It’s not much different than what happens to your savings when the government starts printing too much money.
Extra shares can be issued for a variety of reasons, but one common source is “convertible preferred shares” — a special class of stock that allows the holder to convert those shares to common stock. (Preferred shares, which often pay a special dividend, are really more like bonds than stocks.)
As companies issue more of these shares, the impact of the potential conversion is often overlooked by investors who don’t know — or don’t take the time to learn — just how much preferred stock is out there.
So when you see, for example, a company’s profits reported on a “fully diluted per share basis” it just means those results take into account the number of common shares that may not be on the open market now, but could be if those preferred shareholders decide to convert to common.
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The terms Revenue and Income are often used in reporting earnings. What is the difference?
Audrey W.
Revenue (sometimes called sales) refers to all the money a company takes in from doing what it does — whether making goods or providing services. Other sources of funds — including investment gains — are usually labeled as such but also included as revenue. (Occasionally, you’ll see this number referred to as “gross income.”)
“Net income” is the phrase commonly used to refer to a company’s “profit.” It represents how much money the company has left over, if any, after it’s paid the costs of doing business — payroll, raw materials, taxes, interest on loans, etc..
The real issue is what goes into that income number. There are many flavors: “income from continuing operations,” for example, includes profits made this year from the same businesses, plans, and services that were around a year ago. (Operations that were sold or closed are excluded, on the theory that they won’t generate any more money for investors.) Some people like to look at EBITDA-a gobbledygook Wall Street phrase that means earnings before interest, taxes, depreciation and amortization. In other words, income before those costs have been subtracted.
Over time, companies began to exclude all sorts of things from their “operating income” — with the effect of artificially inflating the profits they reported. When a company pays stock options to executives, for example, those don’t count as “costs” — even though many analysts and accountants think they should.
About the best you can do is try to compare apples to apples — from one quarter to the next, or one company to another. But even that takes a bit of digging.
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