In my search for an outstanding investment, I always start with the company’s income statement. Income statements tell the investor the results of the company’s operations for a set period of time. Traditionally, they are reported for each three month period and at the end of the year.
An income statement has 3 basic components:
Revenue of the business.
Expenses of the business.
Profit (loss) earned by the company.
Sound simple.
Revenue
This is first line on the income statement. This is the amount of money which came in by selling the products during the period of time, which is reported either quarterly or yearly. If we manufacture watches and sell INR 200 million worth of watches in a year, we will report INR 200 million of total revenue for the year on our yearly income statement.
A company with a lot of revenue doesn’t mean that it is earning a profit. For that we need to deduct the total expenses from its total revenues to get net earnings. Since total revenue itself tells us nothing we need to dig deeper into expenses.
Cost of Goods Sold/Raw material (COGS)
On the income statement, just below the total revenues comes the COGS which is the cost of materials and labour used in manufacturing the products.
Note that if the company is in the business of providing services then this line will not appear in the income statement and in that case the net earnings will be calculated by subtracting Cost of Revenue from total revenues.
COGS = (Cost of Inventory at start of year) + (Cost of adding Inventory during the year) – (Cost of Inventory left at the end of the year)
Gross Profit
If we subtract the from the company’s total revenue the COGS, we get the company’s reported gross profit. An example: total revenue of INR 5 million less COGS of INR 2 million equals gross profit of INR 3 million. Gross profit in itself tells us very less so we move on to next topic i.e. Gross Profit Margin.
Gross Profit Margin
GPM = Gross profit / Total revenues
Companies which have excellent long term economics have consistently higher gross profit margins than those that don’t.
What creates a higher profit margin is the company’s competitive advantage among its sector which allows it the freedom to price the products and services it sells well in excess of its COGS. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling.
As a very general rule (with some exceptions):
Companies with Competitive Advantage = GPM > 40% & consistently increasing for the past 5 years.
Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins.
While the GPM is not fail-safe, it is an early indicator of company’s competitive advantage. In upcoming sections we will see a number of ways in which a GPM may strip of its long term advantages.
Operating Expenses
These are all company’s hard costs associated with
R&D,
Selling & administration costs,
Depreciation and amortization costs &
All other non-operating, non-recurring costs.
We will discuss them in detail in upcoming sections.
Selling, General & Administrative Expenses
SGA costs is where the company reports its costs for direct & indirect selling expenses & all general & administrative expenses incurred during the accounting period. These include management salaries, advertising, travel costs, legal fees, commissions, all payroll costs etc.
They vary from business to business. Companies that don’t have competitive advantage suffer from fierce competition and show wild variation in SGA costs as a percentage of gross profit. What happens if the sales start to fall, which means revenue falls, but SGA costs remain. If the company can’t cut SGA costs fast enough, they start eating into more and more of the company’s gross profits.
In a search for companies with competitive advantage:
SGA costs / Gross profit < 30%
Research & Development
This is the big one in the game of identifying companies with competitive advantage. If the competitive advantage is the result of some technological advancement, there is always the threat that newer technology will replace it. Today’s competitive advantage may end up becoming tomorrow’s obsolescence.
Not only these companies spend huge sums of money on R&D, but because they are constantly having to invent new products they must also redesign and update their sales programs, which means heavy spending on SGA costs.
As a general rule (with exceptions):
Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economies at risk, which means they are not a sure thing.
Depreciation
All machinery and buildings eventually wear out over time, this wearing out isrecognized on the income statement as depreciation.
Imagine buying a paper mill named ABC paper mill. The buying of the paper mill on the balance sheet cause INR 10 million to come out of cash and INR 1 million to be added to plant and equipment. Then for the next ten years the depreciated cost of INR 1 million a year will show up on the income statement as an expense. On the balance sheet each year INR 1 million will be subtracted from the plant and equipment asset account and INR 1 million added to the accumulated depreciation liability account. The actual INR 1 million will show up under cash flow statement as capital expenditures.
The companies with competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.
As a general rule for finding a company with competitive edge,
Depreciation / Gross Profit < 8 %
Finance cost
It is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability. This is not an operating cost because it is not tied to any production or sales. Instead it reflect the total debt that the company is carrying on its books. The more debt the company has the more interest it has to pay.
Companies with high finance costs are of two types:
A company with very large capital expenditure required to stay competitive.
A company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.
In any given sector the company with the lowest ratio of interest payments to operating income is usually the company most likely with competitive advantage.
As a general rule,
Finance costs / Operating income < 15%
Profit before Tax (PBT)
PBT is a company’s income after all expenses have been deducted, but before income tax has been subtracted. PBT itself doesn’t tell much about competitive advantage of a company.
Profit after Tax (PAT)
After all the expenses and taxes have been deducted from company’s revenue, we get the company’s net earnings. This is the real money that company made after paying income taxes.
The company should show a historical upward trend in net earnings. A single entry is worthless but the consistency is important in determining competitive advantage of a company. The ride doesn’t have to be smooth, but the historical upward trend is should be intact.
As a general rule (with exceptions):
Net earnings / Total revenues > 20% & must show an historical upward trend
Per-share Earnings (EPS)
EPS are the net earnings of the company on a per-share basis for the time period in question. The more a company earns per share the higher its stock price is. To determine the company’s per-share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding.
While no one yearly EPS figure can be used to identify a company with a durable competitive advantage, a per-share earnings for a period of ten years can give us a very clear picture of whether the company has a long-term competitive advantage in its favour.
As a general rule for finding a company with competitive advantage:
EPS over a ten year period that shows consistency and an upward trend.
Consistent earnings are usually a sign that the company is selling a product or mix of products that don’t need to go through the expensive process of change.
But the EPS with erratic downward trend, punctuated with losses, tells that this company is in fiercely competitive industry prone to booms and busts. The boom shows up when demand is greater than supply, but when demand is great, the company increases production to meet demand, which increases costs and eventually leads to an excess of supply in the industry. Excess leads to falling prices, which means that the company loses money until the next boom comes along.
Leave a Reply