Coins in Stacks

A Practical Example of Direct Profitability

Coins in Stacks

In recent weeks, we have published two articles (here and here) on direct profitability and its potential use as a dimension of expected returns. Since these articles were somewhat abstract in nature and focused on very generalized results, we wanted to switch gears in this article and show via a real life example how profitability could be applied in practice when building an index fund. We will use two companies that everybody is familiar with: Apple and Google, both of which fall into the “mega cap” category with a market capitalization in excess of $100 billion.

Suppose that shortly after the end of 2011, we were evaluating the financial results of these two companies. We would have seen the following:

Year Ending 12/31/2011

($millions)

                                                          Apple           Google

Operating Income                              $33,790          $11,742

(-) Interest Expense                           $0                   $58

Direct Profitability                               $33,790          $11,684

 

Book Value                                        $76,615          $58,145

 

Direct Profitability Ratio                     0.44                0.20

 

Book-to-Market Ratio                         0.24                0.28

 

Market Capitalization (Estimated)      $322,000        $209,000

Source: Morningstar ®

 

Here is a summary of where we are at so far: A $1,000 investment in Apple got you $240 of book value, and that $240 of book value carried $106 of direct profits. A $1,000 investment in Google got you $280 of book value, and that $280 of book value carried $56 of direct profits. Thus, it would appear that for the immediate future, an investment in Apple would have substantially higher earnings than an equivalent investment in Google.

If we were taking profitability into consideration in the construction of our index portfolio, we would have assigned a higher weight to Apple relative to Google. Note that from the difference in market capitalizations alone, we would have assigned an approximately 54% higher weight to Apple. In this case, a heavier tilt towards Apple would have paid off nicely, as seen in the difference in total returns below:

 

                              Apple       Google

2012 Return              32.71%    9.52%

Source: Morningstar ®

Please note that this is just one example, and there are many, many cases where a higher profitability was not associated with a higher return. With our own Apple and Google example, we need look no further than the following year. At the end of 2012, Apple and Google still  had similar book-to-market ratios while Apple’s direct profitability ratio remained more than twice as high as Google’s, and here are the returns so far in 2013:

 

                                                            Apple       Google

Year-to-Date 8/31/2013 Return                -6.80%    19.72%

Source: Morningstar ®

We hope that this example has provided you with a better understanding of how direct profitability may be used in the construction of index portfolios. We should expect that in some years a tilt towards profitability will have a negative payoff, just as it does for the risk factors of small cap and value.