Revenues – this is value of total sales done by the company during the period under consideration. For a value investor, one must understand the real business – what is the company actually selling? Based on this, one can make some simple assumptions about the future prospects of the business.
Revenues can be simply put as:
Number of units sold * Price per unit
So effectively, the number of units sold or price per unit or both factors can be the growth drivers for a company’s revenues. A new hot dog stall will probably have to sell more hot dogs as there is not much scope to depend on the price per hot dog. When a company reaches a stage where the number of items sold starts to stagnate, it needs to be seen if the company can increase the price per unit. If the answer is yes, then the company has a recognized product for which people are willing to pay more. If the price of Coke increases from $1 to $1.1 per can, would you still buy it? Of course!
Cost of Goods Sold – This shows the cost of making the product being sold. So for a hot dog business, it would involve cost of getting the meat trimmings, fat, salt, pepper, sauce etc.
Gross Profit – It is the difference between Revenues and Cost of Goods Sold. It shows how much value is added to the product. A particular ratio which is very insightful for a value investor is Gross Margin, defined as below:
Gross Margin (%) = Gross Profit/ Revenues
If we have a trend of Gross Margin for a company, several things can be inferred from it:
- Competitive position of the company: If the company has been able to maintain it’s margins in the trend, chances are that the customers value the products/services. Ideally we want to select companies that have upward trending or stable margins. Anything above 40%-45% indicates that the company may have a strong position in the market.
- Nature of the business: For example, a company making a product vs a company which only sells someone else’s product. A company only selling someone else’s product is not adding a lot of value to the process, so most likely it’s margins will be low. This will be more clear with the example I am going to show below.
Here we are comparing the Gross Margins of Gilead Sciences (GILD) and McKesson Corp (MCK). Observations from the comparison above:
- GILD has margins in the range of 75% – 85% for the last 10 years
- MCK has very tiny Gross margins in the range of 5%-6%
Gilead (GILD) is a specialty pharmaceutical company with products targeting diseases like HIV, liver diseases, Hepatitis C etc. Clearly the company is adding a lot of value and hence has been able to mark up the price with healthy margins.
McKesson (MCK), on the other hand, is one of the largest medical distributor companies in the US. But it is the nature of its business that doesn’t allow higher margins. So to earn more, MCK depends on more sales i.e. number of units sold.
Hope this has made it a bit clear as to why understanding of the business is so important before investing.
Chapter 4: Operating expenses (SG&A; R&D; Depreciation)