Oil Industry Profits: Analysis of Recent Performance
Released: 2005-08-04T00:00:00

Profit Performance

Introduction

Profit analysis may be carried out using total profits and their yearly growth, or with profitrates. Total profit analysis is useful in evaluating the effect of the industry's profitability onexpenditure flows within the economy as well as the potential command over resources held bycompanies in the industry. Yearly growth of profits can show whether the industry is becomingmore or less of a factor in over-all expenditure flows in the economy.

Profit analysis based on profit rates is useful in examining the effectiveness of the firm'smanagement in using available resources. Profit rate analysis is also useful in making comparisonsbased on the relative performance of firms in the industry and is widely used by investment analysts.

In this report, the focus is on total profits and the growth of profits within the oil industry andthe likely uses of profits by the industry, specifically the potential ability of the industry to invest inoil supply related projects. (4)

Profits in the oil industry have been volatile over the past three decades, reflecting oil pricechanges as well as other market effects. For example, net income for the major energy companies,as defined by the Energy Information Administration (EIA), increased almost threefold by 1981,compared to 1977, on the oil price increases associated with the Iran-Iraq war. By 1986, net incomesof the major energy companies had sunk below 1977 levels. Profits peaked and declined at leastthree other times during the period 1987-2002. (5) Volatility in the price of oil, which leads to volatility in profits,makes investment planning risky. Investments which might qualify for implementation if a high oilprice is assumed may not qualify if a lower price of oil is assumed. This uncertainty may havecontributed to the cyclical nature of investment and capacity expansion in the industry.

Major Oil Company Profits in 2004

Oil industry profits are widely identified as related to world oil price levels. Figure 1 showsthe movement of the monthly price of WTI crude oil at Cushing, Oklahoma from 2003 through2005. (6)

Figure 1. Spot Price of WTI, 2003-2005

Upward pressure on the price of WTI, which began in 2003, strengthened during the summerof 2004, leading to peak price levels in October 2004. The daily peak price for the year, $55.17 perbarrel of WTI, occurred in late October. The average price of WTI for the second half of 2004,$46.01 per barrel, was 25%, or almost $10 per barrel, higher than the average price for the first sixmonths of the year, which was $36.79 per barrel. If the profit performance of the oil industry wasbased, or related, only to the price of oil, given normal lags in the production chain betweenproducing crude oil and distributing petroleum products, it might have been expected that profitsmight have risen late in 2004 and into 2005.

Table 1. Refiners Composite Acquisition Cost of Crude Oil,2003-2005, Quarterly

(dollars per barrel)

Source: Energy Information Administration, Petroleum Marketing Monthly, June 2005, Table 1, p.5.

Although the price of WTI attracts the most headlines through its association with both thefuture and spot market prices, a more reliable measure of the real cost of crude oil to the nation'srefiners is the refiner's acquisition cost of crude oil as shown in Table 1 for 2003 through 2005. Thiscomposite cost measure is a weighted average of the cost of domestic and imported crude oils usedby refiners and also reflects the mix of various qualities of crude oils used in refineries.

Refineries of different levels of technological complexity can use different mixes of crudeoil to produce varying mixes of petroleum products within technological limits. This ability to varythe production mix can be used to enhance profitability when price differentials between sweet lightand heavy sour crude oils or between light and heavy product mixes change. Figure 2 shows thedifference between light and heavy crude oils was generally less than $10 per barrel during theperiod 1992 to 2002. The spread increased in 2004 and into 2005. The average monthly differencebetween light and heavy crude oil in 2003 was approximately $7 per barrel. The average differenceincreased to over $10 per barrel in 2004, approaching $15 per barrel at times. For the first threemonths of 2005, the differential remained at approximately $12 per barrel. (7)

Figure 2. Real Price Difference Between Light Crude Oil and Heavy Crude Oil,1978-2003

Source : Energy Information Administration, Performance Profiles of Major Producers 2003, March2005, Figure 31, p. 31.

Figure 3 shows the movement of the monthly spot market price of reformulated regulargasoline at New York harbor during 2003 and 2004. (8)

Figure 3. U.S. Spot Market Price for Reformulated Regular Gasoline, New YorkHarbor, 2003-2005

After a relatively stable year in 2003, gasoline prices peaked twice in 2004, reaching recordnominal levels. The first peak, of almost $1.41 per gallon, occurred in May, before the summerdriving season began in the United States. The second peak, of almost $1.38 per gallon, occurredin October. The timing of these peaks are similar to those observed in the crude oil market. Pricescontinued to be high in 2005, with a peak price of over $1.52 per gallon attained in April 2005.

The high gasoline prices of 2004 also brought what some identified as a partial decouplingof the oil and gasoline markets. Fears related to limited refinery capacity, low inventory levels, andstrong demand growth in China and other parts of the world led some analysts to conclude that gasoline prices might remain high even if crude oil markets weakened. These conditions might beexpected to yield high margins for refiners.

Table 2 reports the basic financial performance of the major integrated oil companies from2002 through 2004.

Table 2. Financial Performance of the Major Integrated Oil Companies, 2002-2004

(million of dollars)

Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8; andFinancial Data by Company at http://www.Hoovers.com .

Aggregate net income rose in 2004 for the major integrated oil companies, compared to 2003,which itself was a strong year for industry profit performance, and rose by an even greater amountcompared to 2002. Only ExxonMobil (17.8%) experienced a gain of less than 20%, and onlyMarathon (-4.5%) experienced lower net income in 2004 than in 2003. Five of the companies in thisgroup posted net income gains in excess of 50% for 2004, while the average gain in net income wasapproximately 40%. Comparing 2004 to a 2002 base, the gains in net income totaled over 175% forthe major integrated oil companies.

Total revenue growth for 2004 compared to 2003 was 35% for the group, which was less thanthe 44% growth in net income, suggesting that possibly the greater profitability of the major oilcompanies in 2004 did not arise solely from the higher price of crude oil. Compared to 2002,revenue growth for 2004 was approximately 70%, less than the 175% growth in net income for the same period.

The profit rate on sales for this group of oil companies, based on the totals of revenue andnet income reported in Table 2, were 7% for 2004, 6.5% for 2003, and 4.3% in 2002. The growthin the profit rate experienced by these companies suggests that the stronger underlying marketfundamentals in the crude oil and oil product markets were successfully translated into increasedperformance by the companies.

Table 3 shows the upstream (exploration, development, and production) performance of themajor integrated oil companies in 2004. This segment of the firms' business accounted forapproximately 60% of the net income for the group.

Table 3. Upstream Financial Performance of the MajorIntegrated Oil Companies, 2004

(millions of dollars)

Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8.

As shown in Table 3 , increased net income was not derived from large increases in oil andgas production for most companies. For 2004, more than half of the companies produced less oilduring this year of high prices than they did in 2003. The total increase in oil production by thegroup of 1.9% was largely attributable to the 19% increase of one company, BP. The productionresults for natural gas are even more uniform. Every company, except one, Occidental, producedless natural gas in 2004 than in 2003, yielding a total 3.1% decrease in production from the groupas a whole.

Table 4 reports the downstream (refining and marketing) results for the major integrated oilcompanies. This sector accounts for approximately 23% of the total net income earned by thesecompanies. Data in Table 4 show that net income from this sector increased by almost 100% in2004, compared to 2003, but production increased by only 1.5%. Again, consistent with theupstream results, it seems the integrated oil companies derived increases in net income from priceincreases with little support from increased production in the short term.

Table 4. Downstream Financial Performance of the MajorIntegrated Oil Companies, 2004

(millions of dollars)

Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8.

NA = Not Available.

The recent record of the major integrated oil companies in expanding production of crude oil and oil products may be the result of several factors. Unfavorable geologic and politicalfactors might have inhibited output expansion. While the decision to expand oil and gas productionin the United States is generally based on

the underlying market economics, the geology of many producing regions in the United States maynot support large increases in output, especially without financial investment in new technologies. Many U.S. oil and gas fields have either peaked or are in decline, making it difficult to expandproduction, irrespective of the available price incentives. Overseas, oil and gas production decisionsmay reflect the policies of the host governments, the Organization of Petroleum Exporting Countries(OPEC) quotas, or host nation's tax policies.

Another possible explanation for the relatively slow production response by the majorintegrated oil companies in reaction to high oil prices might be that significant investments arerequired and that the resulting time lags might be long enough to delay the appearance of additionalsupply on the market. The major oil companies have been active in international investment,although a good part of that investment has been in new product technologies, such as gas to liquidsand liquefied natural gas. These projects, requiring multi-billion dollar investments, take up to fiveto seven years to complete. This could be one explanation why little additional output of gasolineand other refined products has appeared to result from higher prices in the short term.

Oil companies are owned by shareholders and managerial performance is evaluated in termsof corporate earnings. It is possible that because of limitations on the ability of the firms to investin additional oil and gas production in the short term, profits have been returned to investors in theform of dividends, or the buy back of shares to enhance the market capitalization of the companies.

Independent Oil Company Profits

The profit picture for the independent oil and gas producers with respect to net incomes andtotal revenues in 2004 was, in some ways, similar to that of the major integrated companies. However, some features of their performance differed from that of the major companies. Table 5 presents data for ten independent producers.

Aggregate net income for the group of 10 independent oil and gas producers in 2004 rose byapproximately the same rate, just below 40%, as that of the major integrated oil companies. Similarly, revenues grew by over 25%. The major difference in the picture for the independent oiland gas producers is that they raised output during 2004 by a multiple of the amounts registered bythe major companies. Oil production was up by over 12.5% and natural gas production rose byalmost 4%. This increased production may, however, be partly the result of asset acquisition by theindependent companies. Over the past several years the major integrated oil companies have soldoff smaller producing fields and facilities which have been acquired by the independent companies. For this reason, it is possible that the increased production in this sector as well as the smallproduction increases recorded by the major companies might be related, and reflect an ownershiptransfer of existing assets.

Table 5. Financial Performance of Independent Oil Companies, 2004

(millionsof dollars)

Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8.

Independent Refiners and Marketers

Independent refiners and marketers are typically only involved in thedownstream activities of the oil industry. They typically purchase crude oil, processit in their refineries, and market the resulting petroleum products either directly toconsumers or wholesale the products to other firms. As shown in Table 6 , thefinancial performance of this sector was the strongest of any in the petroleumindustry, surpassing even the downstream performance of the major integrated oilcompanies that are among their major competitors.

Table 6. Financial Performance of IndependentRefiners and Marketers, 2005

(millions of dollars)

Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005,p. 8.

NA = Not available.

As shown in Table 6 , these firms did expand their product sales in responseto the high prices of 2004. The 9% expansion in product sales by these firms in 2004was about six times the magnitude of the increase in production generated by themajor integrated oil companies in their comparable downstream business, althoughthe independent's production base was smaller. (9) The 9%increase in product sales translated into a 45% increase in revenues which resultedin a 190% increase in net income, with every company in the reporting category,except one, achieving at least triple digit increases. This performance, coupled withthe downstream profitability of the major integrated oil companies, gives somesupport to the viewpoint that, in addition to high oil prices, conditions in thepetroleum product markets, especially gasoline, decoupled from their traditionallinkage to crude oil and generated independent market tightness and higher prices.

Key profit indicators in the refining industry are the gross and net refiningmargins. (10) Table 7 presents data for the twenty four firmsincluded in the EIA's set of major energy companies. (11)

Table 7. Refining Margins,1996-2004

(dollars per barrel)

Source : Energy Information Administration, Performance Profiles of Major EnergyProducers 2003, Table B-32, p. 101, and Financial News for Major EnergyCompanies, updated March 9, 2005, Table 2.

For the years 1996 through 2002, the net refining margin averaged $1.44 perbarrel of refinery throughput. The value of the gross refining margin in 2003 wasapproximately 7 times the average for the previous seven years. The gross marginincreased by a further 29% in 2004 compared to 2003. With domestic refinerythroughput approximately 13.5 million barrels per day, and the gross refining marginapproaching $14 per barrel, the source of the profit performance of the oil companiesdownstream operations and the independent refiners and marketers is clear.

The gross refining margins of 2003 and 2004, which increased by a greaterpercentage than the price of crude oil, are a likely indication that tightness in thegasoline market, which is linked to a refining sector running at nearly full capacity,has led to profits that increased by a larger percentage than the price of crude oil. Another indication of tightness in the refining sector is that imports of finishedgasoline, as well as gasoline blending components, have been increasing and wereat record levels in 2004. It is also true that the number of operating refineries in theUnited States has declined to 149 from a peak of 324 in 1981. No significant newrefineries have been constructed in the United States for a quarter of a century. Therefining capacity growth that has occurred in the United States since 1990 has beenlargely due to improvements made at existing facilities, called capacity creep.

Use of Oil Profits

Refinery Investment

An expansion of refinery capacity in the United States might alleviate theportion of petroleum product price increases not due to the high price of crude oil. Construction of new refineries in the United States would add stability to the supplyof gasoline and other petroleum products; the current capacity is stretched nearly tothe limit to accommodate growing petroleum product demand. In addition, thegrowing U.S. dependence on imported gasoline and petroleum products would bereduced. Re-investing profit into a growing, profitable business is also a normalbusiness strategy. However, current conditions may limit potential expansion.

The key factor in determining whether new refinery capacity will beconstructed in the United States is the underlying economics. An oil companyseeking to meet gasoline demand in the U.S. market can do that in any of three ways. The company can either expand existing refineries, build a new refinery, or importadditional gasoline from overseas. The economics dictate that companies choose thecheapest alternative, given that all gasoline will sell for the same price, irrespectiveof source. In 2005, it is likely that the cheapest source of gasoline is through imports. Europe is thought to have surplus gasoline capacity as their vehicle fleet is intransition to diesel fuel, and refineries are still largely oriented toward now excessgasoline production. (12) Expansion of existing refineries is likely the nextcheapest source of product. Expansion of existing refineries avoids many, or all, ofthe fixed costs associated with a new refinery and allows firms to benefit fromeconomies of scale in the refining process. Construction of new refineries is likelythe most expensive source of new product.

As shown in Table 7 , not only have the returns to refiners been low, onaverage, but they have also been volatile. Even recent profit performance has notbeen uniformly good. Although returns in 2004 and 2003 were favorable, 2002 wasa year of very low return. As a result of the observed volatility in returns, theindustry might question whether the current increases in profitability are thebeginning of a new era of profitability, or an upward aberration that will be reversedwith the next market correction.

Related to the uncertainty with respect to the permanence of high refiningreturns is a longer term projection for the price of crude oil. Supply increases up anddown the oil supply chain are normally linked to investment. Based on net presentvalue analysis, investment is likely to take place only if the long term, forecastedprice of crude oil is high enough to generate projected cash flows sufficient to justifythe multi-billion dollar costs of major petroleum projects. If the companies useprojected oil prices in the $25 to $35 per barrel range in investment planningdecisions, limited extra investment and supply expansion can be expected to develop. One oil analyst has asserted that prices might need to remain in the $50 to $80 perbarrel range for a sustained period for investment to occur in sufficient volume tobuild up a comfortable cushion of spare oil production capability. (13)

A reluctance to invest based on current price levels might reflect historicalexperience with the price-investment-supply dynamic of the oil market. As a result of the rise in the price of crude oil associated with the Iran-Iraq War of 1979-80,supply from non-OPEC sources increased and demand declined. Prices during thisperiod reached real values (corrected for inflation) of between $50 and $80 per barrel,and then declined to a nominal value of $11 per barrel by 1985. Investmentsundertaken early in the decade based on an expectation of continued high priceswould have likely not been profitable in the market conditions that actually evolved.

Refinery investment trends over the past two decades have been influencedby environmental compliance requirements. EIA has studied the effect of refineryinvestment required by environmental regulations, and its relationship to profitability. The EIA report found that return on investment in the refining industry was reducedby 42% from 1996 to 2001 as a result of mandated investment expenditures. (14) Theindustry is currently preparing to expand and introduce low sulfur gasoline and dieselfuels. These investment requirements may claim a share of the companies capitalbudget and reduce returns, in parallel with past experience.

The permitting process has been identified by some as an impediment torefinery investment in the United States. Critics contend that even if it is possible toassemble all of the necessary permits to construct a refinery, the long time linerequired for approvals will tend to make the investment less attractive. One examplethat has been cited concerning the length of the time required for the permittingprocess associated with the possible construction of a new, grassroots refinery, is thefacility planned to be constructed near Yuma, Arizona. The refinery has an estimatedcost of $2.5 billion, a capacity of 150,000 barrels per day and is to be located onvacant desert land owned by the federal government. The refinery is planned byArizona Clean Fuels, formerly Maricopa Refining. The refinery is scheduled toprocess imported Mexican crude oil. The refineries output of gasoline is to bemarketed in southern California, an area which has a tight product market becauseof limited pipeline access to major U.S. refineries on the Gulf coast as well otherfactors. (15)

The company first applied for an air permit in 1999 at another Arizona site. The application was withdrawn in 2004. Local groups opposed the project based onpossible health and environmental risks. The U.S. Environmental Protection Agencydecided not to object to an air permit for the refinery on March 21, 2005. Thecompany awaits an air permit from the Arizona Department of EnvironmentalQuality, expected to be issued in 2005. After that permit is obtained approximatelytwo dozen additional permits need to be obtained, ranging from a county permit forzoning approval to a presidential permit from the U.S. State Department to allow theimportation of Mexican crude oil. (16)

The tight petroleum products market in California, with the resulting highprices, as well as the generally good returns to refining since 2000 have maintainedinterest in this project. The long delays in construction start-up might have led to theproject being cancelled if the underlying economics, especially in the Californiamarket, had not been so strong in recent years.

Mergers and Acquisitions

The oil industry of today has evolved to its current structure partly throughyears of mergers, acquisitions, and joint ventures. In May 2004, the GovernmentAccountability Office (GAO) released a study on the effects of mergers and the restructuring of the U.S. petroleum industry. (17) GAOfound that between 1991 and 2000 there were over 2,600 mergers, acquisitions, andjoint ventures in the U.S. petroleum industry. A majority of the transactions tookplace in the last five years of the decade. The transactions took place at all stages inthe chain of production, from exploration and production, through refining andmarketing. These transactions included deals among the very largest oil companies. For example, in 1999 Exxon Corporation acquired Mobil Oil; in 1998 BritishPetroleum and Amoco formed BP-Amoco, which acquired ARCO in 2000; and in2001 ChevronTexaco was formed.

Merger activity is again on the rise in the U.S. petroleum industry. In April2005, ChevronTexaco made a $17 billion stock and cash bid to acquire Unocal, thenumber 9 oil company in the United States, ranked by reserves of crude oil. Unocalwas also targeted for takeover by CNOOC Ltd., a company majority-owned by theChinese government, in a bid that has since been withdrawn. (18) In the samemonth, Valero Energy Corp. bid to acquire Premcor Inc., to form the largest refiningcompany in the United States in a $6 billion deal.

As a result of the profitability of the last year, companies with large cashreserves on their balance sheets are searching for ways to better position themselveson the world oil market, increase their crude oil reserves and other assets, and createeconomies of scale and cost savings. Individually, they are able to accomplish thesegoals through mergers and acquisitions. In addition, a large amount of accumulatedprofits is returned to investors, usually at a premium price, through these transactions.

Although these transactions may improve the market position of the firmsinvolved and imply the expenditure of billions of dollars of accumulated profit, theydo little to improve the nation's demand and supply balance with respect to oil andpetroleum products in the near term.

Dividends and Share Purchases(19)

The firms that make up the oil industry are private firms that use shareholdercapital to engage in business operations. When they make profits they are obligedto return those profits to shareholders, unless management deems it likely thatbusiness opportunities exist such that reinvestment will yield even larger futureprofits for shareholders.

The major oil companies have increased dividends for shareholders, but ingeneral, by less than increases in available funds. For example, ExxonMobilincreased quarterly dividends by $0.02 per share during 2004, an increase of about8%. However, during the last quarter of 2004 earnings per share increased by $0.42,an increase of about 47%. For the years 2002 through 2004, earning per shareincreased from $1.68 to $3.89, an increase of approximately 130%, but dividends,the amount actually paid out to shareholders, increased by only about 15%. ExxonMobil did however reduce the number of shares outstanding over the periodby about 300 million, to 6.4 billion from 6.7 billion. If a company re-purchases itsshares, the value of shares outstanding is likely to increase and the company maychoose to re-sell them on the market if it needs capital in the future. ExxonMobilalso held over $18 billion in cash at the end of 2004, an increase of 75% over theyear.

A similar dividend strategy was in place at ChevronTexaco, where quarterlydividends increased by $0.03 per share during 2004, an increase of about 8%, whileearnings per share almost doubled compared to levels attained in the last quarter of2003. For ChevronTexaco, earnings per share increased over the period 2002 to2004 by an approximate factor of 10, from $0.54 to $6.28, while yearly dividends pershare increase from $1.40 to $1.53, an increase of about 9%. The number ofChevronTexaco shares outstanding declined by about 29 million.

ConocoPhillips, over the period 2002 through 2004 increased yearlydividends from $0.74 per share to $0.90 per share, an increase of about 21%. However, earnings per share increased from a loss of $0.31 in 2002 to $5.81 in 2004. ConocoPhillips increased the number of shares outstanding over the period by about34 million.

Limited dividend payouts, coupled with a modest expansion of investmentin relation to profit has left oil companies highly liquid and well positioned to takeadvantage of future market opportunities.

Conclusion

Since oil price increases began in 2004, the oil industry has earned increasedprofits. These profits might have resulted from other factors in addition to theincreased price of oil. A key factor in increased profitability might be the tightnessin the U.S. gasoline market, a factor related to the lack of enough refinery capacityto meet U.S. demand for petroleum products.

If oil and petroleum product prices are to decrease, supply will likely have toincrease relative to demand. Expanded supply results from investment in the variousstages of the oil industry production process, from exploration and development ofnew oil fields to increased refinery capacity. If the underlying economic parametersand the regulatory environment are not encouraging, investment might not beundertaken. Historically volatile prices and profit levels coupled with a tightregulatory environment contribute to industry uncertainty.

Other legitimate uses for earned profits include paying higher dividends andretiring outstanding shares, acquiring assets through merger and acquisition, andinvesting in new product areas. These uses of profit may benefit shareholders andstrategically position the firm in the global market, but they do less to expand thesupply of oil and products on the market and thereby reduce prices for consumers.

As a result of significant time lags that tend to occur in the oil industry, it maybe too soon to know whether or not investments in the industry, if taken, will resultin the increased supply of oil and petroleum products needed to reduce prices andconsumers' costs.

Appendix: Measuring Profit

In a market economy, a firm's key measure of success is its ability to earn aprofit. Profit is important to firms because it is a signal to the financial markets andinvestors that the firm is worthy of funding either through debt or equity capital. Firms that earn less profit than expected by the market have difficulty fundinginvestment opportunities with negative implications for growth. Firms thatconsistently earn less than adequate profits tend to experience slow growth,stagnation, and ultimately, failure.

Profit is seemingly a simple concept. Total cost is subtracted from totalrevenue, leaving a residual, total profit. In this approach, profit is measured indollars. For the oil industry, the simple total revenue minus total cost approach iscomplicated by the difficulty in neatly separating the revenue-generating outputs ofthe firms from the cost-creating production inputs. For any given oil company, crudeoil price changes may affect both the revenues and costs of the company. If thecompany is an upstream producer and sells crude oil, the production of crude oil isrevenue generating. However, downstream operations, notably refining andmarketing, make use of crude oil as a raw material, and for them, the acquisition ofcrude oil is a cost. As a result, it is not always clear that an increase in the price ofcrude oil will raise, or lower, profits for firms with differing positions in the upstreamand downstream segments of the industry.

Another key factor in the profit calculation is how easily the increase in thecost of crude oil can be passed on to consumers in the form of higher prices forgasoline and other refined products without suffering a more than proportionatedecrease in sales. If cost increases can be passed on to consumers, and the firm hassignificant upstream business interests, then it is more likely that an increase in theprice of crude oil will yield increased profits.

A simple way to rank companies, for comparative purposes, is by total profit. However, this type of simple ranking is likely to provide a misleading picture of therelative performance of the companies in the oil industry.

While the total dollar value of profit is important, it may be equally importantto know the value of the resources, or assets, at a firm's disposal that were used toearn a given dollar level of profit. The size of the firm relative to the level of totalprofit is important, especially for investment analysts. For this reason, the mostcommonly used measures of profit in investment analysis are expressed aspercentages, or rates, independent of specific magnitudes. The use of percentagesallows meaningful comparisons to be made between companies of different sizes anddiffering access to resources.

Profit also can be measured to include or exclude special, non-recurring itemsthat may temporarily affect a company's revenues and costs. For example, if acompany incurs substantial costs and legal penalties associated with anenvironmental cleanup due to an oil spill at one of its facilities, its profit performancefor the relevant time period might well be negatively affected. However, profitnumbers that include the costs resulting from the spill may tell potential investorsand other interested parties little about the real, continuing, business performance ofthe company. (20) Profits from continuing operations, excludingone-time charges (or revenues), may be more informative for some purposes.

All stakeholders in a company do not necessarily have an interest in the sameconceptual definition of profit. Accountants are interested in profit calculations thatmeet generally accepted accounting practices and are consistent with the tax code. Economists use profit as a signal to judge the efficiency of resource allocationdecisions and include opportunity costs in their calculations. (21) Potentialinvestors in the company's stocks and bonds may choose to evaluate profit from astill different perspective, comparing profit to a measure of the assets managementhad available for business purposes relative to the risk the company faced.

The Profit Rate

Even once the efficacy of using a profit rate is determined, measurementissues still need to be addressed. Since profit as a rate, or percentage, must beexpressed relative to some base, an appropriate base must be specified. Threepossible bases, widely used in business analysis, are sales, assets, and net worth, orshareholder equity. Each is useful in answering particular questions about theoperation of the business, but none necessarily serves as an all-purpose profitmeasure.

The profit margin on sales uses the total sales revenue of the business as thebase and expresses profit, or net income, as a percentage of sales revenue. Profitrates expressed in this manner can answer questions as to whether increasing salesbecome more or less profitable as the business grows. (22) This profitmeasure can also lead analysts to basic questions as to whether the businesses' priceswere too low or too high, or whether adequate cost controls were in place as thebusiness expanded. A variation on this profit measure results from replacing netincome in the calculation with operating income. (23)

Profits based on assets, or the return on assets, divides profit, or net income,by the value of the total assets of the business. This measure allows analysts todetermine how well management uses the asset base of the company to generateprofits for investors. If the asset base represents the tools available to managementto carry out business activities, the return on assets gives an indication of howeffective management has been in using those tools. This approach has beencriticized by some because certain "intangibles" important to the functioning of thebusiness may not receive adequate weight in this measure.

A profitability rate popular with potential investors is the return on equity, orthe return on net worth. This measure divides profit, or net income, by the value ofshareholders equity in the firm. Since the fundamental accounting identity, Assets=Liabilities + Owners Equity, must always hold, for every business, this profit rate isgenerally greater than, and at least equal to, the return on assets. (24) Thismeasure is especially interesting to investors who might plan to buy shares of stockin the business. While this profit measure may be revealing to potential investors,care should be exercised in its use. If two businesses have the same asset value andthe same level of profits, differences in return on net worth can arise solely as a resultof the amount of debt financing on the firm's balance sheet, a difference purely offinancial structure, unrelated to a firm's ability to efficiently produce goods and earnrevenues from selling goods. This can generate misleading conclusions about thestrength of the firm's performance, because the choice of financial structure for abusiness is not generally related to its current profitability from continuingoperations.

Another measure, sometimes identified with profitability, is earnings pershare. This measure divides profit, or net income, by the total number of shares ofcommon stock outstanding. Earnings per share provides the prospective maximumof dividends per share that might be paid by the firm. However, it is not a relevantmeasure to evaluate profit. Like the return on net worth, it is affected by the capitalstructure of the company, the division between equity and debt financing. Earningsper share can also be directly affected by strategic management decisions. Firms maydecide to buy back shares of common stock and retire them, holding them as treasuryshares. This type of strategy raises earnings per share by decreasing the number ofoutstanding shares over which any level of net income is divided. This strategymight well be viewed negatively by financial analysts, who might interpret it as asignal that the firm does not have, or recognize, profitable investment opportunitiesavailable, and hence chooses to return to shareholders the money they had investedin the company.

An important factor in analyzing profit data is that in many cases it is moreinformative to use comparative analysis. Comparisons can be made over time, withother companies in the same industry, or with other companies that bear the samelevel of risk.

Time-based comparative profit analysis may be helpful because it suggeststhe direction the company is heading, or the direction of market trends. A particularrate of profit might be viewed as favorable if it was embedded in a trend of risingprofit rates, or unfavorable if embedded in a trend of falling profit rates. Time trendsmight also help to identify correlations between profit and other factors whichinfluence profits. In addition, key lags that affect profit are also more likely to beidentified in a time trend.

Standing alone, any rate of profit might be difficult to evaluate. Comparisonscan be drawn with other firms in the same, or closely related, lines of business todetermine whether a particular firm is a profit leader, average, or a low profit earnerwithin its industry cohort. Barring special circumstances, which should be clearlyreported in the company's financial statements, if two firms in the same line ofbusiness, with approximately the same asset base, report very different profit rates,it is possible that this differential might suggest that one or the other firm'smanagement strategy is superior. Looking at profit rates of different sized firmswithin the same industry allows the analyst to assess whether growth of the firm toa larger scale may imply any advantage or disadvantage with respect to profit.

In some cases, particularly for investment decisions, the most relevantcomparison is with firms with a comparable level of risk, independent of the line of business in which the firms are engaged. (25) This approach is appropriate for prospectiveinvestors because they may have less interest in what business activity a firmundertakes, than the results of that activity in terms of profits earned and risk borne. In many cases, profits can be expressed in comparison to an index of firms designedto show average, or market, returns and risk.