Saturday, September 09, 2006

More Net Profit

Net Profit may be subjected to multiple rounds of creative accounting (i.e. legally faking no.s or cooking the books to produce no.s) but it does measure the profit that should go to shareholders. To put it into another perspective, if the company has integrity and assuming that it does not cook its books, then Net Profit is a true measure of the profit attributable to shareholders.

As a rule of thumb, Net Profit should be 50-70% of Operating Profit. This is worked below:

Assuming that a company has $100 in operating profit, then
Operating Profit $100
Recurring Profit $90 (say interest expense is 10% of OP)
No XO loss or gain as it should be
Tax rate 20% (i.e. tax is $18)
Net Profit $72

Hence a good co. would have a Net Profit of roughly 50-70% of OP, depending largely on the tax rate. In Singapore, however, there are a few companies that has Net Profit that is greater than Operating Profit. This is usually because they have a lot of profit gained after OP like sale of investment in stocks, properties or simply income from cash holdings.

The most prominent example is SPH. For several years, SPH sold various investments that it held in Singapore stocks like Starhub, M1 etc. These huge gains from investments are allocated at the Recurring Profit level and hence even after taxes are deducted, Net Profit is much higher than it should be, sometimes even higher than OP.

P&L Reloaded: Net Profit

The Net Profit is usually the last line in the P&L statement and is usually the number that is most looked at. In reality, this no. bears little significance to the operations of the company.

Net Profit has little to do with the company’s business because it measures a lot of "costs" that are progressively less relevant to the company's core operations. To recap, we all know that the most relevant costs of any business operations will be

Cost of Goods Sold (COGS)
Sales, General and Adminstrative Expenses (SG&A)

The no. after these costs are subtracted is the Operating Profit (OP). After OP, interest expenses are deducted, because lenders take the first cut of what is left as they always do. Of course the some companies do not borrow, so they have interest income instead. The number after interest is accounted for is called by various names like Recurring Profit or Ordinary Profit or Earnings Before Tax and extraordinary items etc.

After this, we have extraordinary losses or gains (also known as XO loss or gain). This is where companies hide all the bad stuff usually and you see extraordinary losses or gains every year, which makes you wonder if they are extraordinary or exactly ordinary.

After that, we have taxes and after taxes we finally come to Net Profit, which is profit that is attributable to the shareholders of the company. (If you think about it, shareholders are ranked behind 1. Customers 2. Workers, 3. Debt holders, 4. Disasters 5. the Taxman, which makes investors the lowest lifeform.) You must understand that at every level, no.s are subjected to manipulation and hence when it comes to Net Profit, this no. actually has no integrity left.

Nevertheless, when Net Profit is divided by the no. of shares outstanding (i.e. no. of shares issued by the company which is still in circulation), we get another big ticket no. called EPS, or earnings per share. EPS is the most talked about no. on Wall Street because it is used to calculate the Price Earnings Ratio, or P/E ratio. And this ratio determines how cheap or expensive is the stock.

The Guru = Warren Buffet (a.k.a. Sage of Omaha)

With numerous references to The Guru on this blog, I reckon I should give a proper introduction to the person who made this blog's existence a reality. This is really for those who are asking yourselves, "Who is Warren Buffett?".


Warren Buffett is the world's 2nd richest man and the world's first person to donate 85% of his enormous wealth (which is roughly USD 40bn or 40% of Singapore's GDP) to charity. Imagine the whole of Singapore donating 40% of their salary to NKF.


He is also a practitioner in a style of investing known as Value Investing which has made a handful of people very rich. This is the reason why it is promoted on this blog.


For a detailed biography of Warren Buffett, try googling him or alternatively you can go to this link at Wikipedia on Buffett. No, I am sorry, Warren Buffett does not have a blog. He only tried going online a few days ago to play bridge with other people not living in Omaha, which is somewhere in the middle of nowhere in US.

The Greater Fool Theory

The Greater Fool Theory or Greater Fool Game looks at stock bubbles, Ponzi scheme and MLM from another perspective. Essentially you try to get into the game as early as possible and sell your stuff to the next person or the Greater Fool. Now the next person is the Greater Fool because by buying what you have proposed to sell, he probably doesn't gain anything (or every little). Try visualizing magnetic beds or slimming pills or purple crystals that claim to do wonders but the effects are impossible to quantify.

So the only way he can get out of this trap is to find a Greater Fool (than himself) and sell it to him. As long as you are not the Greatest Fool, you will win the game. In MLM and Ponzi scheme, the Greatest Fools are people at the lowest level of the pyramid. The reason why MLM and other Ponzi Scheme and stock bubbles can carry on for some time is because the Greatest Fool or Fools have not joined yet. So those in the game can continue to have fun.

A true value investor however, does not like to participate in the Greater Fool Game. He believes in buying things below their intrinsic value and in the Greater Fool Theory, intrinsic value of any product or stock is way, way, way below its market value. (i.e. you are buying something worth $1 with $100.)

There is no right or wrong about making money. Depending on your investment philosophy, you can engage in Greater Fool Games all your life and make truckloads of monies. And throw a few shillings to the down-and-out value investor staying true to his philosophy. (FYI: Warren Buffett lost 50% of his wealth during the IT bubble by staying true to his invesment philosophy.)

Just make sure that you are not the Greatest Fool.

The Pyramid or Ponzi Scheme and the Positive Feedback Loop

A bubble is very much similar to a Pyramid Scheme or Ponzi Scheme. These are essentially elaborated setup that promise riches to those who join but are bound to fail because they are not based on fundamentally sound economics.

A Pyramid Scheme or Ponzi Scheme (also exhibited in other forms like Rat Society, MLM, etc) has two characteristics:


1) The person who joins have to cough up some amt of money
2) The person can recruit others to join under him, the recruits in turn cough up an amt and the person on top gets a cut


This scheme essentially benefits early birds as they are the ones who can enjoy more income as more and more people join. But it is bound to fail because it is not based on fundamental economic growth and no. of people who will join will eventually run out.


However at the start, the early birds usually enjoy some success. This is because as more people join them, they see money rolling in and they reaped back their initial investment. This is called the Positive Feedback Loop.


The success of the early birds convinced them and their friends that the scheme worked and they fervently recruit more people. This is what happens in stock bubbles. Early adopters buy stocks and see their wealth grow. They spread the word, more people join them. But since this is not based on real economic growth, at some point, there will be less buyers than sellers and everything collapses.


MLM is an ingenious way that masks a product into the Ponzi Scheme. The selling price is set ridiculously high to feed those at the top of the pyramid. But it is also bound to fail because there will be a point where you simply cannot get any more buyers to cough out those exorbitant rates for mildly useful health products, magnetic beds or the other shady products with unmeasurable usefulness.


The same goes for internet ads promising huge returns in days or weeks. It will only work if you are an early bird. Chances that you are an early bird is as good as finding a $10 bill in the middle of Orchard Road. (i.e. very low lah, bcos someone would have picked it up. But not impossible.)