[SOLVED] While net income is an obviously useful

While net income is an obviously useful indicator of a firm’s profit-generating ability, it has equally obvious limitations. Net income will grow with a simple increase in the scale of the operation. A 2% savings account will display growing interest income over time but would scarcely represent a good long-term investment. Similarly, a company that generates profit growth of only 2% per year would seldom turn out to be a good investment. In the same way, investors must be careful in their interpretation of earnings per share numbers. These numbers are artificially affected by the number of outstanding shares. Following a 2:1 stock split, for example, the number of shares outstanding will double, while share price and earnings per share will fall by one-half. However, such a stock split neither enhances nor detracts from the economic appeal of a company. Because the number of outstanding shares is wholly determined by vote of the company’s stockholders, the specific earnings per share number for any given company at any point in time is somewhat arbitrary. Earnings per share numbers are only significant on a relative basis. At any point in time, the earnings per share number for a firm is relatively meaningless, but the rate of growth in earnings per share over time is a fundamentally important determinant of future share prices.
Because absolute measures, like net income, paint only an incomplete picture of corporate profitability, various relative measures of profitability are typically relied upon by investors. First among these is the accounting rate of return on stockholders’ equity (ROE) measure. Simply referred to as ROE, the return on stockholders’ equity measure is defined as net income divided by the book value of stockholders’ equity, where stockholders’ equity is the book value of total assets minus total liabilities. ROE tells how profitable a company is in terms of each dollar invested by shareholders and reflects the effects of both operating and financial leverage. A limitation of ROE is that it can sometimes be unduly influenced by share buybacks and other types of corporate restructuring. According to Generally Accepted Accounting Principles (GAAP), the book value of stockholders’ equity is simply the amount of money committed to the enterprise by stockholders. It is calculated as the sum of paid in capital and retained earnings, minus any amount paid for share repurchases. When “extraordinary” or “unusual” charges are significant, the book value of stockholders’ equity is reduced, and ROE can become inflated. Similarly, when share repurchases are at market prices that exceed the book value per share, book value per share falls and ROE rises. Given the difficulty of interpreting ROE for companies that have undergone significant restructuring, and for highly leveraged companies, some investors focus on the return on assets, or net income divided by the book value of total assets. Like ROE, return on assets (ROA) captures the effects of managerial operating decisions. ROA also tends to be less affected than ROE by the amount of financial leverage employed. As such, ROE has some advantages over ROA as a fundamental measure of business profits. Irrespective of whether net income, profit margin, ROE, ROA, or some other measure of business profits is employed, consistency requires using a common basis for between- firm comparisons.
Table 11.2 shows ROE data for 30 of the most consistently profitable companies found within the Standard and Poor’s 500 stock index. Beer titan Anheuser-Busch Companies, Inc.; personal products and drug manufacturer Johnson & Johnson, and consumer goods goliath Procter & Gamble Co. are enormously profitable when profits are measured using ROE. To get some useful perspective on the source of these enormous profits, it is worth considering the individual economic factors that contribute to high levels of ROE: profit margin, total asset turnover, and financial leverage. Among these three potential sources of high ROE, high profit margins are the most attractive contributing factor because high profit margins usually mean that high rates of ROE are sustainable for an extended period. Profit margins show the amount of profit earned per dollar of sales revenue. On a per unit basis, profit margins can be expressed as π/Sales = P-AC/P. When profit margins are high, the company is operating at a high level of efficiency, competitive pressure is modest, or both. In a competitive market, P = MC=AC, so profit margins converge toward zero as competitive pressures increase. Conversely, P > MC in monopoly markets, so profit margins can be expected to rise as competitive pressures decrease. High profit margins are clear evidence that the firm is selling distinctive products.
Considering the effects of profit margins on the market value of the firm is a simple means for getting some interesting perspective on the importance of profit margins as an indicator of the firm’s ability to sustain superior profitability. The market value of the firm represents the stock market’s assessment of the firm’s future earnings power. If high profit margins suggest attractive profit rates in the future, then profit margins should have a statistically significant impact on the current market value of the firm. An attractive way to measure the stock market’s assessment of profit margin data is to study the link between profit margins and the firm’s P/E ratio. In the P/E ratio, “P” stands for the company’s stock price, and “E” stands for company earnings, both measured on a per share basis. P/E ratios are high when investors see current profits as high, durable, and/or rapidly growing; P/E ratios are low when investors see current profits as insufficient, vulnerable, or shrinking.
The P/E ratio effects of ROE, profit margin, total asset turnover, and financial leverage for consistently profitable corporate giants found within the S&P 500 are shown in Table 11.3.
a. Describe some of the advantages and disadvantages of ROE as a measure of corporate profitability. What is a typical level of ROE, and how does one know if the ROE reported by a given company reflects an adequate return on investment?
b. Define the profit margin, total asset turnover, and financial leverage components of ROE. Discuss the advantages and disadvantages of each of these potential sources of high ROE.
c. Based upon the findings reported in Table 11.3, discuss the relation between P/E ratios and profit margins, total asset turnover, and financial leverage. In general, which component of ROE is the most useful indicator of the firm’s ability to sustain high profit rates in the future?

Question: While net income is an obviously useful