Prosperity is an instrument to be used, not a deity to be worshiped.
Are we killing our company by making too much money? I believe this is a possibility, and I'd like to explain the situation and present some ways of remedying it. But first, since it involves some fairly arcane financial concepts, some background is required. I covered these matters in more detail in Information Letter 12, written on July 20th, 1985 (see page ). Here I'll give only a brief summary, sufficient for understanding the discussion that follows.
When a company sells something and gets paid for it, that's Sales. Out of that, the company has to pay its bills: the cost of raw materials, salaries, rent, commissions to sales agents, interest on debt, and so forth. What's left is Pre-tax Earnings, and if it's less than zero the company is losing money. Next in line are the tax collectors, and what doesn't go into their pockets is After-tax Earnings, or plain Earnings. Dividing Earnings by Sales gives the Margin, the percentage of sales that ends up as profit. If the company is a stock corporation, you can divide the total earnings by the number of shares outstanding and get Earnings Per Share or EPS. When the stock is selling at a given Price, dividing the share price by the EPS gives the Price/Earnings Ratio or P/E.
These numbers indicate the general state of health of companies and industries. Here are some real numbers for real companies.
|Bank of America||11389.0||820.0||7%||9|
Amazing, isn't it, to think that Autodesk and Microsoft make more than two and half times the profit per dollar of sales than IBM? Isn't software neat? Looking at the P/E column indicates investors think it's awfully neat. So neat they're willing to bid up the price of a share of our stock or Microsoft's to between 22 and 34 times the yearly earnings that share represents, while they're only willing to pay between 8 and 18 times the earnings for companies with sales dozens of times larger and histories spanning decades.
The reason software stocks command these high premiums (which translate directly into the price of the stock), is that they've demonstrated they can run large profits while continuing to grow rapidly. This is usually the case for companies in a rapidly-expanding market. Once the market becomes mature, growth slows, market share battles erupt, and margins fall as companies spend more and more winning customers from their competitors.
Investors and analysts have learned to watch a company's margins closely. Changes in margin are often among the earliest signs of changes in the fortunes of a company, for good or for ill. When sales, earnings, and margins are rising all together, it usually means the market for the company's products is growing even faster than the company anticipated; the future seems bright. When margins begin to decline, however, it can indicate the company has let spending outpace sales. When competition begins to affect the company, or even when a company fears future competition, it may spend more on promotion, accelerate product development, and offer incentives to dealers and retail customers--all reflected in falling margins.
But high margins aren't necessarily a good thing, particularly in the long term. One way to post high margins is by neglecting investment in the company's future. Any profitable company can increase its earnings and margin in the short run by curtailing development of new products and improvements to existing products, by slashing marketing and promotional expenses, and by scaling back the infrastructure that supports further growth. Since there's a pipeline anywhere from six months to several years between current spending and visible effects in the market, sales aren't affected right away. So, with sales constant or rising slowly and expenses down, earnings and margin soar and everybody is happy.
For a while, anyway. Eventually momentum runs out and it's obvious the company can't sustain its growth without new products, adequate promotion, and all the other things that constitute investment in the future of the business. It's at that point the company becomes vulnerable to competitors who took a longer view of the market.
One of the most difficult and important decisions the management of a company makes is choosing the level of investment in the future of the business. Spend too little, and you're a hero in the short term but your company doesn't last long. Spend too much, and the company and its stock falls from favour because it can't match the earnings of comparable companies. Unlike many choices in which there is relatively little room for maneuver, the level of reinvestment can vary widely. After all, Autodesk could have spent $40 million more last year and still earned more on every sales dollar than IBM.
When a company is running margins too high to sustain, the situation can be discerned by the following kind of symptoms. Product release dates are stretched out, and each product release contains less substantive content. Marketing and other promotional activities are cut back, abandoning products to sell themselves. Budgets for the development and promotion of new products are slashed, sacrificing future sales and earnings from those products to current earnings.
It's how a company dies by making too much money.
Editor: John Walker