Some Thoughts on Investing - Part 1

I was reading Warren Buffett's letters to shareholders from the 1970s and came across a performance measurement ratio he used when evaluating the performance of Berkshire's performance - Operating Income on Beginning Equity Capital.  The rationale behind not using earnings increase year over year is that "there's nothing particular noteworthy in a management performance combining a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings per share each year because of compounding. "

To better understand this, I wrote a simple business scenario and compiled the financial statement by myself.

Let's say we started a juice business with $2000 bank loans and $3000 equity capital (3000 shares with $1 par value). We then bought 4 juicers for $250 each and other fixed assets (such as desks, chairs, credit card processing machines) for another $2,000. Our beginning balance sheet will look like

Cash              2,000
Juicer             1,000
Fixed Assets:  2000
Total Assets:  5,000

Bank Loans:  2,000
Equity:           3,000
Total L+E:     5,000

Here are the assumptions:
We can sell 30 cups per day, or 10,950 cups per year
Sale price is $5 per cup.
Cost of sales is $2 per cup.
Rent Expense is $12,000 annually
Utilities and Electricity is $2,400 annually
Interest expense rate is 5%, or $100 annually.
Juicers and fixed assets are depreciated straight-line using 5 years, which means depre exp= $600 annually.
Other expenses: $100
Tax rate: 30%

Our Income Statement will look like:                    

Sales :                             $54,750
Cost of Goods Sold:          21,900
Gross Profit:                      32,850

Rent expense:                    12,000
Utilities and Electricity:         2,400
Depreciation Expense:            600
Interest Expense:                    100
Other Expense:                       100
Total Operation Expense: $15,200

Income from Operations:  17,650

Income Taxes:                    5,295

Net Income:                     12,775

Earnings per Share:            4.26


Our Balance Sheet will look like this:

Cash:                        $15, 375
Juicer (net)                        800
Other Fixed Assets:          1600
Total Assets:              $17,775

Bank Loans:                  2,000
Equity:                         15,775
Total L+E                    17,775



Our key ratios and stats for year 1 are as follows:

1. Gross Profit Margin: 60%
2. Operating Margin:  32.2%
3. Net Margin:  23%
4. BV per share: 5.26
5. Return on Beginning Equity: 426%
6. EPS: 4.26

Now, assuming in year 2, we didn't not buy new juicers and all other information stay the same. Our income statement will look exactly the same, our balance sheet will look like this:

Cash:                       $28,750
Juicer:                             600
Other Fixed Assets:       1,200
Total Assets              $30,550

Bank Loans:                 2,000
Equity:                       28,550
Total L+E                 30,550


Our key ratios and stats for year 2 are as follows:

1. Gross Profit Margin: 60%
2. Operating Margin:  32.2%
3. Net Margin:  23%
4. BV per share: 9.52
5. Return on Beginning Equity: 81%
6. EPS: 4.26

In year 3, again, we didn't not buy new juicers and all other information stay the same. Our income statement will look exactly the same, our balance sheet will look like this:



Cash:                       $42,125
Juicer:                             400
Other Fixed Assets:         800
Total Assets              $43,325

Bank Loans:                 2,000
Equity:                       41,325
Total L+E                 43,325


Our key ratios and stats for year 2 are as follows:

1. Gross Profit Margin: 60%
2. Operating Margin:  32.2%
3. Net Margin:  23%
4. BV per share: 13.78
5. Return on Beginning Equity: 44.8%
6. EPS: 4.26

This scenario unfortunately did not give me a better understanding of Return on Beginning Equity Capital. However, I accidentally stumbled onto the following implications based on this exercise:

1. This scenario essentially illustrates a business model with low reinvestment (capital) need, high fixed cost, high cash flow generation, and high ROA and ROE in prospering years. We may see situations like this in Retail and For-Profit Education industries a lot.
2. This business model will do extremely well in booming years because once you covers fixed cost, every sales dollar will add to the bottom line. On the other hand, this business model is extremely cyclical as high operating leverage will magnify the impact of decrease in sales.
3. A great business with this business model should have pricing power and can differentiate its product. A perfect example is See's Candy.
4. Non-controlling stockholders may not do as well as owners, especially if the equity interest is purchased at a later stage. Even though BV will increase every year, EPS is stagnant. Mathematical illustration is as follows:

If we use book value as a proxy of intrinsic value:
Year 1: Both BV and IV increase by 81%.
Year 2: Both BV and IV increase by 44.75%
Year 3: Both BV and IV increase by  31%
........
Year 10: Both BV and IV increase by 10.82%
.....
Year 20: Both BV and IV increase by  5.2%

Here we are subject to the law of diminishing returns. While the early equityholders enjoy fabulous returns in early years, later equityholders may face only mediocre return. This may be the case for Abercrombie and Fitch.

5. In order for the business to grow earnings per share, the owners must have the courage and determination to make investment that will generate returns in excess of cost of capital.   The best business will be able expand by opening more stores, expanding to new markets or increase prices of the products consistently. Urban outfitters, Coca Cola and See's Candy are good examples.