Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists, and a key component of deciding to invest or to remain invested in a company. There are many metrics involved in calculating profitability, but for this article, I will look at PepsiCo’s (NYSE:PEP ) earnings and earnings growth, profit margins, profitability ratios, and cash flow.

Through the above-mentioned four main metrics, we will be able to understand more about the company’s profitability. By comparing this summary to other companies in the same sector, you will be able see which has been the most profitable.

Earnings and Earnings Growth

1. Earnings = Sales x Profit Margin

• 2010 — $57.838 billion x 10.93% = $6.320 billion
• 2011 — $66.504 billion x 9.69% = $6.443 billion

PepsiCo’s earnings increased from $6.320 billion in 2010 to $6.443 billion in 2011, but the profit margin decreased.

2. Five-year historical look at earnings growth

• 2007 — $5.682 billion, 10.54% increase over 2006
• 2008 — $5.142 billion, 10.50% decrease
• 2009 — $5.946 billion, 15.64% increase
• 2010 — $6.320 billion, 6.29% increase
• 2011 — $6.443 billion, 1.95% increase

In analyzing PepsiCo’s earnings growth over the past five years, you can see a positive earnings trend. Even though the company reported a down year in 2008, the overall trend is positive. Over the past five years, PepsiCo’s earnings have been increasing and have shown a 13.39% increase over its 2007 earnings.

Profit Margins

3. Gross Profit = Total Sales — Cost of Sales

In analyzing a company, gross profit is very important because it indicates how efficiently management uses labor and supplies in the production process. More specifically, it can be used to calculate gross profit margin. Here are gross profits for the past two years:

• 2010 — $57.838 billion — $26.575 billion = $31.263 billion
• 2011 — $66.504 billion — $31.593 billion = $34.911 billion

4. Gross Profit Margin = Gross Income / Sales

The gross profit margin is a measurement of a company’s manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/ sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

In analyzing PepsiCo’s gross margin over the past five years you can see very consistent results. The 2011 gross margin is the highest margin at 54.30%, while the lowest margin is 52.49%.

• 2007 — $21.436 billion / $39.474 billion = 54.30%
• 2008 — $22.900 billion / $43.251 billion = 52.95%
• 2009 — $23.133 billion / $43.232 billion = 53.51%
• 2010 — $31.263 billion / $57.838 billion = 54.05%
• 2011 — $34.911 billion / $66.504 billion = 52.49%

The consistency in the gross margin implies that management has been very consistent in their efficiency of manufacturing and distribution during the production process.

5. Operating income = Total Sales — Operating Expenses

The amount of profit realized from the operations of a business after taking out operating expenses — such as cost of goods sold (COGS) or wages — and depreciation. Operating income takes the gross income (revenue minus COGS) and subtracts other operating expenses, then removes depreciation. These operating expenses are costs that are incurred from operating activities, and include things such as office supplies and heat and power.

• 2010 — $8.332 billion
• 2011 — $9.633 billion

6. Operating Margin = Operating Income / Total Sales

Operating margin is a measure of the proportion of a company’s revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. If a company’s margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

Over the past five years, PepsiCo’s operating margin has been good with 2009 reporting the highest operating margin in the last five years at 18.61%. The operating margins of 2010 and 2011 have slipped compared to the previous three years:

• 2007 — $7.182 billion / $39.474 billion = 18.19%
• 2008 — $6.959 billion / $43.251 billion = 16.09%
• 2009 — $8.044 billion / $43.232 billion = 18.61%
• 2010 — $8.332 billion / $57.838 billion = 14.41%
• 2011 — $9.633 billion / $66.504 billion = 14.48%

As the operating margin has slipped over the past two years, this implies that there has been less percentage of total sales left over, for paying for variable costs of production, such as wages and raw materials.

7. Net Profit Margin = Net Income / Total Sales

A ratio of profitability calculated as net income divided by revenue, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

PepsiCo’s net profit margin has steadily decreasing over the past five years. In 2007, PepsiCo reported a net profit margin of 14.39%, while in 2011 the company reported a net profit margin of 9.69%. This is a decreased in margin of 48.50%.

• 2007 — $5.682 billion / $39.474 billion = 14.39%
• 2008 — $5.142 billion / $43.251 billion = 11.89%
• 2009 — $5.946 billion / $43.232 billion = 13.75%
• 2010 — $6.320 billion / $57.838 billion = 10.93%
• 2011 — $6.443 billion / $66.504 billion = 9.69%

As PepsiCo’s net profit margin has been trending lower for the past five years, this implies the company is not able to keep the same percentage of its earnings as in previous years. This is one area of the company to be aware of going forward.

8. SG&A % Sales = SG&A / Total Sales

Reported on the income statement, it is the sum of all direct and indirect selling expenses, and all general and administrative expenses of a company. High SG&A expenses can be a serious problem for almost any business. Examining this figure as a percentage of sales or net income compared with other companies in the same industry can provide insight as to whether management is spending efficiently or wasting valuable cash flow.

PepsiCo’s SG&A % sales has been relatively consistent over the past five years. In looking at 2011 SG&A % sales was calculated at 36.74%. This is slightly above the five-year average of 35.99%. As this percentage is slightly above the five-year average this implies that management has been spending more of their sum of all direct and indirect selling expenses compared to the five-year average:

• 2007 — $14.196 billion / $39.474 billion = 35.96%
• 2008 — $15.489 billion / $43.251 billion = 35.81%
• 2009 — $14.612 billion / $43.232 billion = 33.80%
• 2010 — $21.770 billion / $57.838 billion = 37.64%
• 2011 — $24.433 billion / $66.504 billion = 36.74%

Profitability Ratios

9. ROA — Return on Assets = Net Income / Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company’s net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as return on investment.

In looking at PepsiCo’s ROA over the past five years, we can see the ratio has been trending lower. The ROA dropped from 16.41% in 2007 to 8.84% in 2011.

• 2007 — $5.682 billion / $34.628 billion = 16.41%
• 2008 — $5.142 billion / $35.994 billion = 14.29%
• 2009 — $5.946 billion / $39.848 billion = 14.92%
• 2010 — $6.320 billion / $68.153 billion = 9.27%
• 2011 — $6.443 billion / $72.882 billion = 8.84%

The current ROA of 8.84% is lower than the five-year average of 12.74%. This implies that management was less efficient at using the company’s assets to generate earnings compared to its five-year average.

10. ROE — Return on Equity = Net Income / Shareholder’s Equity

As shareholder equity is measured as a firm’s total assets minus its total liabilities, it reveals the amount of net income returned as a percentage of shareholders equity. The return on equity measures a corporation’s profitability by revealing how much profit a company generates with the amount shareholders are invested.

• 2007 — $5.682 billion / $17.325 billion = 32.80%
• 2008 — $5.142 billion / $12.106 billion = 42.47%
• 2009 — $5.946 billion / $16.804 billion = 35.38%
• 2010 — $6.320 billion / $21.273 billion = 29.71%
• 2011 — $6.443 billion / $20.745 billion = 31.06%

Over the past five years PepsiCo’s ROE has been quite volatile, with a high in 2008 of 42.47% and a low in 2010 of 29.71%. The 2011 ROE of 31.06% is below the five-year average of 34.28% revealing that the company is generating less profits off of the shareholders equity compared to its five-year average.

Cash Flows

11. Free Cash Flow = Operating Cash Flow — Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt.

It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.

Over the past five years, PepsiCo’s free cash flow has been positive and increasing:

• 2007 — $6.934 billion — $2.430 billion = $4.504 billion
• 2008 — $6.999 billion — $2.446 billion = $4.553 billion
• 2009 — $6.796 billion — $2.128 billion = $4.668 billion
• 2010 — $8.448 billion — $3.253 billion = $5.195 billion
• 2011 — $8.944 billion — $3.339 billion = $5.605 billion

The latest number, also on the plus side, indicates that PepsiCo has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.

12. Cash Flow Margin = Cash Flow From Operating Activities / Total Sales

The higher the percentage, the more cash available from sales. If a company is generating a negative cash flow, it shows up as a negative number in the numerator in the cash flow margin equation. This means that, even if the company is generating sales revenue, it is losing money. The company will have to borrow money or raise money through investors in order to keep on operating.

PepsiCo’s cash flow margin is positive, so it does not have to take these measures to continue operating:

• 2007 — $6.934 billion / $39.474 billion = 17.57%
• 2008 — $6.999 billion / $43.251 billion = 16.18%
• 2009 — $6.796 billion / $43.232 billion = 15.72%
• 2010 — $8.448 billion / $57.838 billion = 14.61%
• 2011 — $8.944 billion / $66.504 billion = 13.45%

Summary

In analyzing PepsiCo’s earnings growth over the past five years, you can see a positive earnings trend. Even though the company reported a down year in 2008 the overall trend is positive. Over the past five years, PepsiCo’s earnings have been increasing and have shown a 13.39% increase over its 2007 earnings.

As illustrated above, the profit margins have shown mixed results. The gross profit margin has been relatively even while the current operating, net profit and SG&A margins have all been trending to the negative side. These margins are one area of the company to keep an eye on going forward.

Like the profitability margins the ROA has shown a declining trend line, with the 2011 ROA being considerably lower than the five-year average. The ROE is holding up much better but is still below the five-year average. Again, these are more areas to watch going forward.

With free cash flow and the free cash flow margin both displaying increasing results and positive cash, PepsiCo has enough cash to develop new products, make acquisitions, pay dividends and reduce debt without having to borrow or raise money to maintain operations.

The analysis of PepsiCo’s profitability tells the story of a strong company with lots of cash but some declining margins. Over the past five years, earnings have been increasing, while some of the listed profit margins have been slipping. Currently PepsiCo has a large amount of free cash at hand, which does bode well for the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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