The COVID 19 pandemic accelerated an existing trend in share markets around the world – the influx of youthful investors.

Many and perhaps most of these newcomers to share market investing are like babes in the woods – they know little or even nothing about the game they are about to play. This observation led to an increase in stock market literacy sources on the internet. Here in Australia a notable example was the arrival of CommSec Learn, an educational site added to the investing arm of our largest bank – the Commonwealth Bank of Australia.

There is one thing all newcomers to share market investing have in common – they are there to make money. Common sense tells them for the investor to make money, the company whose stock they purchase must make money. Profit, they reason, is the ultimate goal.

There is no shortage of articles touting the merits of particular stocks on financial websites across Australia, but the best resource for investors is arguably the financial reporting released by the companies themselves twice a year –  Full Year results and Half Year results. In the US, regulations there require financial reporting quarterly.

There is a dizzying array of information in a company’s financial reporting, but the line many investors gravitate towards immediately is NPAT, or net profit after tax.

 

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Understanding Net Profit After Tax

In its pure form, NPAT shows investors how much money a company has left from the total revenue it has taken in over the reporting period after all operating costs, financing costs, and taxes have been subtracted from total revenues.

Some financial reporting will begin with gross profit, which is total revenues minus the cost of goods sold, typically including materials and labor.

Costs of goods sold does not include operating costs so the next step is to subtract those costs – rent, utilities, and marketing and distribution expenses, leaving the line investors often see – net profit before tax. 

The final step is to subtract the company’s tax bill to get to the line investors are looking for – net profit after tax. 

A positive NPAT tells investors the company has options for what can be done with the profit – either invest it into future growth opportunities such as new product development or expansion of manufacturing capacity or entry into new markets. Another option often taken by large companies with a solid track record of profitability is to share some of the profits with shareholders in the form of dividend payments.

Some financial reporting includes potential sources of confusion for investors, with line items for statutory net profit after tax and underlying net profit after tax.

Underlying Net Proft After Tax versus Statutory Net Profit After Tax

Statutory net profit after tax includes one-time items unique to the reporting period. As an example, if a company has sold an asset during the period, the funds from the sale are included in the statutory net profit after tax calculation, inflating the company’s profitability which clouds the  profit the company has made from its actual operations.

The opposite also holds true. If a company acquires another company during the reporting period the cost of the acquisition may reduce the statutory net profit after tax in whole or in part depending on the terms of the sale, clouding an accurate picture of the company’s real profit from operations.

The line item that eliminates one-time charges is reported as underlying net profit after tax, sometimes adding the qualifier “from operations.”

Share market newcomers are sometimes befuddled when they cannot find NPAT in a company’s reporting but they do find the reported EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortisation.

Understanding Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA)

Proponents of EBITDA reporting argue that eliminating expenses not related to the company’s actual business operations during the reporting period offers investors a clearer picture of how well the company is performing in its core business. It also allows a better comparison across companies since it eliminates differences in interest payments and accounting and tax strategies.

Proponents also claim EBITDA is more useful for evaluating companies for potential mergers or acquisitions, again because eliminating non-operating expenses exposes the profitability the company is actually achieving from what it does.

NPAT versus EBITDA

The critical difference between these financial metrics can be understood by comparing the meaning of two words – net and before. Net means everything left after all relevant costs have been deducted. The earnings in EBITDA come before certain costs have been deducted.

Proponents favoring NPAT over EBITDA strongly argue that the costs left out of the EBITDA reporting are real costs to the company that do reduce revenues. The concept of “non-operating expenses” is a myth especially when it comes to the interest owed on the company’s debt financing. In addition, deprecation and amortisation reflect real costs of physical assets needed by the company spread out over time.

One of the greatest investors of modern times, US legendary investing “whale” Warren Buffet has this to say about EBITDA, from one of Buffet’s Letters to Berkshire Hathaway Shareholders:

Trumpeting EBITDA is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That is nonsense.

And another comment:

References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures? 

Seasoned long time share market investors know company management goes to great lengths to provide the most positive picture of financial performance during the reporting period, to the point in rare cases of accentuating ad nauseum positive numbers and burying negative results. This might explain financial reporting that proudly touts increases in EBITDA and buries the actual NPAT.

Many experts concur, claiming NPAT is a better measure of a company’s overall profitability and financial health. NPAT considers the company’s accounting practices with included depreciation and amortisation expenses, interest costs due to the company’s debt financing, and tax strategies.

Although companies in the early stages of the business life cycle that have yet to show a profit may be worthy investments, they pose inherently higher risk than already profitable companies.

Profit is the ultimate goal of investors, and the net profit after tax included in a company’s Full Year and Half Year financial reporting provides the most accurate picture of the company’s profitability and overall financial health. Net profit is reported as either statutory – including one-time charges during the reporting period – or underlying, reflecting profit from the company’s operations during the period.

EBITDA is another measure of a company’s profitability from its core operations, but it eliminates accounting and financing costs and taxes.