(By Ugodre Obi-Chukwu)
“Warren Buffet popularised the word moat because he felt companies such as Coca-Cola has such a good product that everyone liked it regardless of the alternatives around. One way to determine that a company has that is its ability to sustain high revenue growth. If it consistently grows revenues despite competition then investors believe its current losses will soon reverse either by increasing its selling price or out competing competitors by reducing its price.“
Make no mistakes about it, profits are like food to every business. Without it the business will die in no time no matter how much cash it generates. However, before a business makes profits it must have shown the ability to generate considerable revenues. Without revenues there can’t be profit thus making profits dependant on revenue.
As such, there are times when you see companies making back to back losses yet investors jostle to have a piece of the stock in their portfolio. Why is this so? It boils down to the following.
Is revenue growing – When business is loosing money but yet it appears it is increasing its revenues then it means that the business has a problem managing cost. It could be that its operating expenses is too high and eating away profits. It could also mean that the business took loans and is paying too much in interest to a bank or a financier and based on that has very little.
Is cost cutting going down – Yes, sometimes a business can be running up losses because it has failed to reign in on cost. But then, reigning down on cost does not immediately translate to profit making. It is usually the first step in the right direction and should be a sign that better things are coming. It is however important to ensure that the cost that are being cut are real and not out of some financial engineering.
Are there losses because the company can’t meet up with demand – Some business take time to grow and during this tutelage period can run up losses. The company may be spending so much on research and development (R&D), marketing and promotional cost all in a bid to ensure its product is noticeable and garnering market share. In such cases, what you focus on is revenues and not necessarily profits. An increase in revenue shows that consumers must like the products and demand for it may just be itching up higher.
Is the barrier to entry low – Some business are such that only very few competitors can come in. It is either the owners have a technological patent that can’t be easily replicated or that the investment outlay is just too high. Businesses like that can create a pseudo monopoly which you well know can be a key to market dominance. However, for this to be a competitive advantage investors look at revenue growth as a key driver rather than profits which might seem good in the short term. Once you can show that revenues are growing exponentially then investors know your business really has that ability to sustain profitability growth.
Is the technology a moat – Just as barrier to entry due to technological advantage is great so does a company with an inherent comparative advantage. For example, Warren Buffet popularised the word moat because he felt companies such as Coca-Cola has such a good product that everyone liked it regardless of the alternatives around. One way to determine that a company has that is its ability to sustain high revenue growth. If it consistently grows revenues despite competition then investors believe its current losses will soon reverse either by increasing its selling price or out competing competitors by reducing its price.
One time loss – Some companies face huge losses due to bad bets that results in one-time losses. This is called Exceptional/Extraordinary Items in Accounting and is not expected to occur in future. It could be that the company’s business was affected by a fire, a law suit or a write down of a loss making division. Often times, such losses are taken in to minimise cost and clear the way for a brighter future. It is however, important to note that such instances must be a one off. You have to be sure that the write offs are not a systemic failure within the organisations and the beginning of further losses in the future.
Is the business a low margin business – Low margin businesses mostly walk on the thin line. Examples are oil and gas, supermarket business etc. They trade on huge volumes high operating cost and low profits. Because of this, a sudden rise in operating cost or drop in revenue can lead to a loss. However, a hike in operating cost is often bearable when compared to a drop in revenue. If revenue growth persist then management will always have the opportunity to widen margins by cutting wastes. You do not want to just focus on profits here and get your eyes off the ball which in this case is revenue. If you concentrate on profits alone and disregard revenue, then in no time you may start to rake in losses when revenues drop.
Does the business generate enough cash flow – A profitable business may not necessarily mean the business is a solvent one. You can sell a product which cost you N1000 for N2000 and make a 100%. However, if you do not collect the N2000 cash your profit is as good as gone. Profit to me is earned when you receive the cash from the revenue. So whilst cash is dependant on revenue profit, is dependant on cash and also on revenue.
“Opinion pieces of this sort published on RISE Networks are those of the original authors and do not in anyway represent the thoughts, beliefs and ideas of RISE Networks.”