Applying Value Analysis to Income and Cash Flow

The first things you should ever look at when analyzing a company is its top and bottom lines. How much money is this company making, and how much is it keeping? From there, you can work your way throughout the gritty details about where it is all the money is going, and whether or not you believe in the ability of these expenses to make even more money.

But companies are all different sizes, and they all create competitive advantages by sinking their money into different kinds of investments, so how is it that we can differentiate between similar companies without getting lost in the numbers?

The answer lies with GAAP-based profitability ratios.

The key benefit of profitability ratios is that they reduce a company’s earnings into simple-to-understand metrics that can be easily compared against close competitors. They represent efficiency, and allow us to answer the fundamental question of “where’s the money?”

By putting individual ratios side-by-side, we can understand which competitor is best using its available resources, and therefore isolate the kind of competitive advantage we want to invest in. Below are the major profitability ratios, how to calculate them, and a description of how to recognize competitive advantage in the metric itself.

  • Profit Margin – Net Income/Sales

    A high profit margin represents that a company is keeping a higher percentage return for every dollar invested. However, while a high profit margin represents a great opportunity to invest in cash flows, it can be misleading. High profit margins might simply reflect a tiny company that is not yet able to incur a great deal of expenses.

    Additionally, it could suggest that a company is a leader in a new industry, which means that this margin might wind up decreasing due to new entrants to the industry. What this means is that you must take this ratio into consideration with the actual size of the company, as well as the maturity of the industry itself.

  • Gross Margin – Gross Income/Sales

    A high Gross Margin represents a strong ability to access raw resources, and to produce those resources into a sellable product. The Gross Margin represents scale, and fixed investment, as well as a supply chain relationship. However, a high Gross Margin might simply represent that a company is extremely large, and therefore diluting its gross expenses over its massive scale. Otherwise, a high Gross Margin might represent a heavy investment in fixed infrastructure that will reduce the flexibility of the company’s supply chain.

    The trick to considering this ratio is to take it in consideration against the company’s ability to survive hardship, and to innovate. If a company has spent a great deal of resources into fixed infrastructure, it is important that it still be able to apply that infrastructure towards expansion and endurance.

  • Operating Margin – Operating Income/Sales

    The operating margin is one of my favourites, because it is such a dynamic metric. This is the profitability ratio that you will need to dig further into if you see inconsistencies, because it represents all of the spending that creates a company’s ‘personality’. Marketing expenses, administrative/staff salaries, office equipment, and many other dynamic costs get sunk into this category. The operating ratio therefore represents a company’s ‘know-how’, and the quality of the people that are driving it.

    However, it might also represent a company’s capacity to expand. If a company has a high operating ratio, it is operating very efficiently, but likely without much room to expand its capacity in the short term. However, if it is operating with a low operating ratio, it might simply mean that this company is building up for a big expansion. Take this metric in consideration with the market’s ability to accept growth.