How to invest - part 1. Preparation - How - Sixth Part

Today will be the third item on what to look at, financially: The net profit margin.

Net profit margin is calculated by deducting from your revenue, the following items:
1. cost of goods sold
2. operating expenses aka overheads oka fixed costs
3. depreciation and amortization, interests, and taxes

You may recall from the previous post that gross profit is obtained by deducting your cost of goods sold from your revenue. So, your net profit is really just your gross margins, less all costs other than costs of selling your goods.

Picture this: you sell lemonade for a living, so your revenue is the sales amount from all the cups of lemonade sold. Your gross profit is your sales, less the costs of the lemonades, water, sugar, salt, ice, cups, i.e. all the costs that you need to pay in order to serve that lemonade to your customers. 

Now, other than the costs mentioned, there are other costs you gotta accommodate, in order to operate - these are the costs you would have to incur in running the biz, whether or not you make money - such as the lemonade stand, the icebox, the ice in the icebox to keep whatever in the icebox ice-cool, chair(s) for you to sit on while waiting/tending to customers, a table cloth to place your lemonading equipments, the cash box/register, and the biz license (lol I doubt there needs to be a license for running a lemonade stand but let's just assume the gov is serious about regulating the lemonade business). These are your operating costs - there can be a few variants to this name but the concept is wtv cost you pay to ensure the biz can operate, whether or not you make a sale.

Then there are the truly boring stuff - especially if you run a cash business coz these costs are stuff you don't quite see and feel (for taxes, it's stuff you neither want to see nor feel really). Depreciation and amortization, in a nut shell, is you recognizing your assets this year won't be worth as much the next year - this is because of wear and tear, or the equipment becoming older/obsolete, and because accountants generally need to do something - this recognition is manifested in the real world by deduction against your income. Depreciation is for physical assets like the lemonade stand, jug to store lemonade, chairs etc, while amortization applies to intangible assets like your lemonade stand brand, the website, and trademark of your lemonade stand name.

Think about the car you own - you first got it for say, $100,000.00, then in the 2nd year, you find that the market rate for your car in the second hand market for a two year old car is only $85,000.00 - it's not exactly the same thing but you can think of it as a parallel. This part really becomes useful for tax breaks and for audits.

Interests, well it's pretty straightforward - the interests on any loans you make also need to be deducted against your income. This part also becomes really useful for tax breaks.

Coming to tax, well I don't have much to say other than I wish there wasn't tax but that would mean governments will cease to operate (and is that such a bad idea?). Suffice to say, you make income, there will be a tax on that and there are some steps you can take in an endeavor called tax planning - unfortunately my knowledge, will, and patience for tax matters are as deep as the thickness of an A4 paper and I shall not go any further - just know that tax is always present, and any listed company has to pay tax, and if they don't, they get in big trouble, usually existence-threatening trouble - so any listed company will not or will try their best to keep their taxes in good order, making this an item the least of your worries.

Also, there's a reason why, in the financial statements, the depreciation and amortization, interests and tax are lumped together with income, under a line called EBITDA or earnings before interest, tax, depreciation and amortization.  This is really just taking your gross profit, and deducting your operating expenses to get your total income before considering the effects of depreciation and amortization, and any interests on loans and taxes. 

You can consider this to be your net profit (gross profit after deducting operating expenses), but without the accounting effects of depreciation and amortization - which in theory should give you a "cleaner view of your income"

As a side note,  depreciation and amortization doesn't really affect you in a physical way coz it does not disrupt your cashflow right? You receive cash for selling lemonade (revenue), then you minus of the costs of buying lemons, and preparing & storing the lemonade (cost of goods sold), and after that, you pay for the chairs, banners, and the lemonade stand itself (operating expenses) . No where in this process will you need to pay someone or something the amount you think that your lemonade stand will decrease come next year, or by the amount you estimate your car will be worth less next year. 

Popularised during a time when leveraged buyouts were the rage, EBITDA became the goto number for evaluating a company coz :
1. leveraged buyouts, as the name implies, made use of leverage or high amounts of debt to buy a company - a profitable one with good cashflow
2. As high amounts of debts were issued, naturally the biggest chunk of expense will be your interests on the debts issued.
3. So, by taking by comparing your EBITDA to your interest ratio cover (basically, how well can your profits cover your interest on debt) - you can sort of tell how well your newly bought biz can meet the loan obligations you incurred to buy it out.

Truthfully speaking, I don't really like looking at net profit margin because at every step of the way, you can change abit, tweak a little, charge more, account for less, increase depreciation/amortization and perform some accounting magic (legal magic mind you) in so many other ways that the initial revenue you get may very well turn out to not be a good indicator of biz performance by the time it is net profit. I believe, more revenue, means good business but that's for another day!

How to invest - part 1. Preparation - How - Fifth Part

 Today we will be touching on the Gross Profit margin:

Simply put, Gross Profit: Revenue - Cost of goods sold

Then, Gross Profit Margin : Gross Profit / Revenue

In other words, you take your sales, and minus off whatever cost you directly incurred to make that sale, and you have your gross profit, in dollar amounts.

Then, you divide this gross profit by the sales amount - this tells you how much profit you make per $1 of sales, percentage wise. 

So, if company A makes $100 in revenue, and spends $20 in promotion, hiring temp staff etc, the gross profit is $80 and its gross profit margin is 80% - which is real damn high, but not unusual.

What this % does is, it tells you a couple of things:

1. If you have a company that is high in gross profit margin, it tells you that the profits it makes in relation the costs it needs to spend to make a sale is quite high, and this also tells you the company manages to keep its selling costs low. 

How does a company keep its costs low? Couple of ways: the company manages to source for material cheaply, which may signal the company has a unique hold/access to its raw material(s) or manages to strike a good deal with its supplier and can keep costs low for a certain amount of time

2. Say, you know this industry really well and the prices of its raw materials are quite standardized/commoditized so any company in this industry faces roughly the same costs. So, based on point 1, you think the gross profit margin should be roughly the same for all - but, you noticed there are one or two companies that seem to have higher than average gross profit margin. 

This probably means the company is able to charge a higher price ie bring in more revenue. Now, if you have a company or a few companies that are able to charge higher than its peers in an industry where the cost of goods are about the same, you may think these companies are doing something different.

Perhaps they have a good brand, strong marketing, excellent after sales, awesome customer retention, constant updates and improvements to their existing and new products/services - in warren buffett's terms, the company has a strong moat(s).

Definitely save a company like this in your watchlist for further study !

So, just with gross profit margin, and revenue, you can do abit of preliminary analysis:

1. Check the revenue growth of company A vs the revenue growth of the industry.
If its higher than the industry, it means A is eating up its competitor's share but also pay attention if the revenue growth of the industry starts to decline - it may signal the beginning of the end. Like Kodak and the digital camera market.

2. Compare the gross profit margins between a group of companies in the same industry, and you can kind of get a sense of which companies has good cost management (this does however warrant a deeper dive to get a full understanding of all the other costs a company incurs), good pricing ability, and in turn, good/strong economic moats.

How to invest - part 1. Preparation - How - Fourth Part

We will be talking about Revenue this time.

What is Revenue?

In short, it is sales or how much you as a company makes from providing a service or product to customer. The more sales you make, the more revenue you generate for the year. 

What is special about Revenue?

Simply put, no revenue, no money in the company. 

And no money, no talk as the saying goes.

No revenue, means there's is profits or cash flow. if a  an organization can't bring in money, it will cease to exist. Heck this is even true for not-for-profit organizations!

But, among other things, revenue also represents the confidence the market has in the business, NOT the price of its stock BUT the amount of sales it makes. 

Take for example, you launch a new product and people, your friends and family, and about the 1000 people on social media thinks it's a good product and the hype drives up your cred - that's price of a stock. But, when people wanna put their money where there mouth is at, that's revenue. The clearest way the market validates your business + products/services is when it buys them, not when it supports you via likes/follows/retweets. 

How I identify Revenue?

It is the first line item in income statement (or profit and loss statement - same thing). It is also called sales, turnover, or income

It is separate from profits - which is revenue minus your costs involved in selling. 

 

Key points:

Look for growing revenue, whether year over year or quarter over quarter, look for companies with growing revenue. 

But in particular, check to see if the company's revenue growth is equal or more then the revenue growth of the industry it operates in! If it is, the company is growing faster than the market, and by extension, it is eating up its competitors' market share and gaining a stronger foothold in the industry. 

As a corollary, check the industry revenue growth rate too - if you find in the last 3 years the % has been steadily declining, you might be looking at a sunset industry like newspaper, which will eventually shrink in market size and your company, even if it is number 1 will start to see revenue growth slow down and even reduce.