By: Don Shaughnessy
Profit is a poor proxy for success and investors should not rely on the number without considering other facts.
Strangely a business can become bankrupt while it is profitable. This profit ambiguity causes problems for business owners, managers, policy makers and investors.
What do you mean by profit?
Suppose an incorporated business earns $1,000,000 using the tax rules and generally accepted accounting principles (GAAP) In Ontario, the tax bill would be $220,000 leaving $780,000 to invest. Clearly profitable!
BUT, only within the system of GAAP and taxation. In the real world, the result might well be very different.
Suppose the business must invest $1,500,000 to remain competitive in its industry, (same market share and same technology as the leaders in the industry.) Did it really make a profit or did it really lose $720,000?
The economic answer is it lost $720,000, and even that is not simple.
By investing the profits and borrowing, the business continues to exist and possibly a weak entrant in the industry will become weaker still and succumb. So the true long-term economic loss is actually somewhat smaller. Maybe a lot smaller and possibly not a loss at all. Some of the cash loss is an investment in future market share.
Management faces the task of deciding if they will survive long enough to benefit. Especially true if the government bails out the weak ones.
For those looking at profit alone, other expenses matter too. Marketing, advertising, R&D, employee training and more, pay off over long periods but have immediate cost. Good for tax expense but hard for the analysts to validate. Some other expenses, like pensions, have a visible price today but an unknowable future cost.
In both accounting and taxation, profit is not the result of facts but rather is the result of rules and opinions. Things like depreciation rate, inventory and product obsolescence, bad debts, investment rate to be earned on the pension fund, future technology effects and more.
As an investor, is there anything at all to be gleaned from the financial statements?
In most cases, it makes sense to pay attention to the management letter. I know a high performance fund manager who looks for the words challenge or challenging in that letter. If he sees either he throws the statement away. In his words, “I have only limited resources, so why would I invest with people who have challenges?”
When looking for an investment, use commons sense first. I like the product, I like management, I like the industry and so on. Then look at the numbers.
• “Cash is real, profit is opinion.” Or at least cash is more likely to be real because you go to jail if you fool with it. Not so much with profit.
• Look for dividends. They impose a discipline on management and the cash paid out reduces the homeless dollar problem. When management finds that problem, some pretty dodgy projects get funded.
• When things go wrong, quit quick. Holding losers and waiting for recovery is a losing tactic. The price of tulip bulbs, which peaked in Holland in February 1637, has, as yet, not returned to that high.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. firstname.lastname@example.org