Video Link: https://youtu.be/wKYncNF5sj8
In this episode, Peter Lynch talks about two ways for a company to increase earnings.
In this episode, you’ll learn:
How does reducing costs increase earnings?
How does companies increase revenue?
What is profit margin?
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PETER LYNCH 00:00
There are only two ways for a company to increase earnings. They can increase sales or reduce costs. Most companies work to do both of these things. The income statement can help you figure out if the company is succeeding.
If earnings equal revenues minus costs, then a valid way to raise earnings is to reduce costs. Reducing costs not only pushes up the earnings number, it makes a company more competitive.
If two companies, both produce competitive products of similar quality, then the one who can build it more cheaply has the advantage. They can choose to charge less for the product and sell more than a competitor or can sell it for the same price and make much more money than their competitor.
One way to measure cost reduction is to check out the costs listed on the income statement each quarter. But it is difficult to do so, because what you really care about is how costs are changing relative to revenues.
One way to measure this cost of revenues is the profit margin. This number is not shown on the income statement itself but is calculated for you in the research section of the stock shop. To calculate the number for yourself, just divide the earnings before taxes by the net revenues. The higher the profit margin, the more money the company makes for each product it sells.
Once we have the profit margin as a tool, we can evaluate how successful the company is being in reducing costs. Unless the company has raised prices significantly, if the profit margin goes up then costs are going down relative to revenues.
You can compare the profit margin of the company to the profit margin of a competitor or to the average profit margin of the industry. When a company that is highly profitable already must depend on cost-cutting to boost its profits even further, you have to be skeptical.
If its profit margins are unusually high compared to the rest of the industry, there is a limit to how much additional profit it can squeeze out of the business by economizing. Ask yourself. Is there a long road of margin cutting ahead or are they already extremely efficient? Your goal is to feel as confident as possible with your story.
How does a company plan to increase earnings?
Sales growth is a single most important factor in growing earnings long term. So, you must ask yourself how the company is going to make sales rise. The company can expand its customer base. Selling its existing products to new customers brings in new revenue.
When evaluating this strategy, consider how far the company is from saturating the market or its products. If a company is already selling to 98% of its potential customers, there aren’t a lot left to reach.
The company can introduce new products into its existing customer base. This is the most difficult, but potentially the most rewarding strategy. If the product catches on it can breathe new life into the company. Advantages like brand names and a good reputation come in very useful here.
A company can also raise prices to increase revenues. That way, even though unit sales stay constant, revenues will still grow. Of course, the danger of raising prices is that the higher prices will drive customers to competitors or encourage new competitors to enter the market.
The details of a company’s plan will vary by industry and by individual company. Just make sure you understand that plan and include it in your story.