Entertain Yourself: Part 2

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

How is the dream vacation planning? Disney’s (NYSE: DIS) Shanghai resort and theme park sure sounds like a good option for 2016. (For those that did not read the first part of this analysis, you will want to review the content here.)

To continue, we will look at profitability ratios:

<table> <thead> <tr><th> </th><th>Disney</th><th>Time Warner</th><th>News Corp</th><th>Comcast</th><th>Viacom</th></tr> </thead> <tbody> <tr> <td>PM</td> <td>13.07%</td> <td>10.51%</td> <td>11.65%</td> <td>9.91%</td> <td>16.90%</td> </tr> <tr> <td>ROA</td> <td>7.19%</td> <td>5.87%</td> <td>5.79%</td> <td>3.76%</td> <td>10.27%</td> </tr> <tr> <td>ROE</td> <td>14.71%</td> <td>10.08%</td> <td>14.60%</td> <td>12.46%</td> <td>29.27%</td> </tr> </tbody> </table>

Profit Margin

Profit margin reveals a firm’s net income given its level of sales. One explanation of why Viacom’s (NASDAQ: VIA) PM is highest results from the fact that it does not have as high a percentage of costs. For example, Viacom recorded total sales of nearly $14 billion in 2012 compared to Comcast’s (NASDAQ: CMCSA) total sales of just over $62.5 billion. But, just Comcast’s SGA expenses were nearly 10x that of Viacom. A healthy profit margin means that managers are able to control expenses while maintaining or increasing revenues.

The problem with this metric is that the profit margin on sales does not distinguish between the effect of leverage and the effectiveness of sales in producing profits. So, investors must be cautious when comparing the PM of a highly leveraged firm with the PM of a less leveraged firm. In fact, as you may recall from Part 1, Viacom is more leveraged than the other firms, particularly with long term debt. Therefore, Viacom’s PM is likely inflated, especially when compared to Disney. Again, Disney proves to be a good buy.

Return on Assets

While the ROA provides some insights into how effective firms’ assets are in generating income, the metric is inconsistent. Why? The net income is available to shareholders of the firm, while the total assets represent the investments by both shareholders and creditors. As a result, the ROA compares what one group receives with what two groups invested.

Additionally, it is important to identify line items listed on the firms’ balance sheet when considering the ROA. Comcast, for instance, has over $77 million listed in intangible assets. These non-physical assets are still valuable to Comcast and enable the firm to sustain a competitive advantage; however, (and unfortunately for this metric) they do not directly aid the company in generating income. The result is clear for Comcast—a lower ROA. Be sure to recognize such tendencies; if you do, you will be ahead of the curve.

When considering an investment, look at similar line items that affect particular metrics. You may be surprised to learn that a company with a seemingly inefficient ROA can be a good investment.

Return on Equity

As an investor, your eyes may be drawn to this measure. You must realize, though, that net income is a flow of cash generated throughout the year whereas equity is the “stock” at the end of the year. And moving forward, Viacom has to overcome some tremendous hurdles to maintain a high ROE. Netflix, for example, recently announced higher subscriber growth—nearly matching Time Warner’s (NYSE: TWX) esteemed HBO premium cable channel. As stated in The Wall Street Journal, Netflix does not plan to renew a license in May for Viacom’s Nickelodeon, MTV, and BET networks. Rather, Netflix is interested in particular programs and is even considering offerings from Disney, Hasbro, and other firms. As a result, Viacom needs to cut costs or work on generating revenue; or, it likely will not meet analyst forecasts.

Additionally, News Corp (NASDAQ: NWS) is showing strong signs of growth. Its ROE is up nearly 10% from just under 5% for 2012. CEO Rupert Murdoch also forecasts strong growth into the future. He recently announced that the corporation will be split into two companies. One will specialize in media & entertainment while the other will include the newspaper and publishing industry. As a result, each arm is poised to focus on its niche and acquire other firms without upsetting the valuation or business processes of the other company. Expect to see positive momentum with these two stocks.

Last, we will briefly review two market value ratios:

<table> <thead> <tr><th> </th><th>Disney</th><th>Time Warner</th><th>News Corp</th><th>Comcast</th><th>Viacom</th></tr> </thead> <tbody> <tr> <td>PE </td> <td>19.57</td> <td>19.26</td> <td>18.7</td> <td>17.07</td> <td>15.49</td> </tr> <tr> <td>Book Value/Share</td> <td>22.79</td> <td>32.06</td> <td>12.07</td> <td>18.7</td> <td>14.44</td> </tr> </tbody> </table>

As indicated above, each company has a seemingly strong PE ratio. However, keep your eyes on Time Warner, News Corp, and Disney. Each of these firms anticipates strong growth moving forward, and each is working through new strategies to gain additional market share. Time Warner, for example, recently posted a 5% increase in earnings, even after losing nearly 120,000 video customers in just the first quarter. As a result of executing strategy properly, Time Warner's Chairman and CEO said, “I remain very excited about the long-term prospects." (more detail will be covered in Part 3).

Finally, we see that Time Warner, News Corp, and Comcast are all strong contenders in book value/share. That is, if they were to liquidate, their balance sheet is strong given their respective stock price. This conclusion makes sense, especially given the firms’ current ratio as discussed in Part 1. In short, Time Warner is clearly the winner in this category.

Conclusion

The above ratios indicate that several of the analyzed firms will prove to be fruitful investments. However, each opportunity comes with risk, and you must determine the degree of risk you are willing to embrace.

Part 3 will tie all components together and provide an overview of each company moving forward.


Brendan Marasco has no position in any stocks mentioned. The Motley Fool recommends Walt Disney. The Motley Fool owns shares of Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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