A place to learn how to analyse financial statements and find good companies for investment – using time tested strategies of great investors and traders like Benjamin Graham, Warren Buffet, Joel Greenblatt and William O'Neil
Income before tax (EBIT) = Operating profit – Gain/loss on sale of assets – Other items
Tax expense – It is simply the tax owed by the company to the government
Net Profit = Income before tax – Tax expense
Net Profit is the widely watched item when the earnings results are announced for a company. Whilst growth in absolute numbers is good to watch, it is also advisable to see this number as a percentage of Revenues, i.e. what percentage of Revenues in the concerned period was actually translated into profit that the owners of the company could use for themselves or invest it back in the growth of the company. This measure is called Net Profit Margin (%), expressed as below:
Net Profit Margin (%) = Net Profit/ Revenues
As would be obviously clear by now, more the net profit margin, the better investment it would be.
Please see below the example for Gilead Sciences (GILD) to see the trends of profit margins. Except for a period between 2012 and 2013 when margins dropped to late 20s (which also is arguably very good), the company has been able to maintain margins above 35%.
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.
History of maintaining healthy margins, and hence:
Very good return on Invested capital and return on Equity
Chance to accumulate at relatively cheap valuation
There has been a lot of discussion on Gilead since the Kite acquisition announcement. So I decided to go and check the performance history of the company and am very pleased to share the results.
Gilead is a specialty pharmaceutical company that makes products targeting diseases like HIV, liver diseases, Hepatitis C etc. Recently they announced takeover of KITE, which is working on a revolutionary cancer cure.
Gilead has been operating at very healthy margins for the last ten years, numbers below for your reference:
Gross margin %
Operating margin %
Net margin %
R&D requirement %
What the above numbers indicate is that the management has been doing a good job at recognizing opportunities in the market for income generation (eg. Pharmasset acquisition for Hep C drug in 2012).
Below are the numbers for Return on Equity and Return on Capital – impressive, right? The company has been buying back shares since it’s operation, almost 31% reduction in diluted shares in last 10years, hence increasing the value for the shareholders. The net income grew at CAGR of 25% for last 9 years while the EPS grew by 31% during the same period.
Diluted shares (mm)
Gilead at current P/E of ~9 is very attractive and can be accumulated at dips for long-term holding. Seeing the performance above, I believe the management will be able to find opportunities for growth via fruitful acquisitions.
Disclaimer: I wrote the article myself and it expresses my opinion. I am not receiving compensation for it. I am long GILD and do not intend to buy/sell in next 72 hours. I have no relationship with any company whose names are mentioned in this article.