Is the Net Profit the 'final word' on a company's health?
"To answer your question briefly: net income is affected by many things inside and outside of management control, and must be supplemented by other elements to gain a clear picture of a company's health. To answer your question in-depth, we must look at the history of financial reporting: Initially, accounting was primarily cash-based. That is, a business records a sale when a customer pays them cash, and records expenses when cash goes out the door. This was not a perfectly accurate system, as cashflow might be quite erratic even if sales are stable (collection times may differ, etc.). To combat problems with cash-based accounting, financial reporting moved to an accrual-based system. An accrual is the recording of an item before it has fully completed in a cash transaction. For example, when you ship goods to a customer and they owe you money, you record the revenue - then you record the future collection of cash as a balance sheet item, rather than an income statement item. Another example: if your landlord charges you rent on December 31st for the past year, then in each month leading up to December, you accrue the expense on the income statement, even though you haven't paid the landlord yet. Accrual-based accounting leaves room for accounting manipulation. Enron is a prime example; among other things, they were accruing revenue for sales that had not occurred. This 'accelerated' their income, by having it recorded years before cash was ever collectible. There are specific guidelines that restrict doing things like this, but management will still attempt to accelerate net income as much as possible under accounting guidelines. Public companies have their financial statements audited by unrelated accounting firms - theoretically, they exist to catch material misstatements in the financial statements. Finally, some items impacting profit do not show up in net income - they show up in ""Other Comprehensive Income"" (OCI). OCI is meant to show items that occurred in the year, but were outside of management control. For example, changes in the value of foreign subsidiaries, due to fluctuations in currency exchange rates. Or changes in the value of company pension plan, which are impacted by the stock market. However, while OCI is meant to pick up all non-management-caused items, it is a grey area and may not be 100% representative of this idea. So in theory, net income is meant to represent items within management control. However, given the grey area in accounting interpretation, net income may be 'accelerated', and it also may include some items that occurred by some 'random business fluke' outside of company control. Finally, consider that financial statements are prepared months after the last year-end. So a company may show great profit for 2015 when statements come out in March, but perhaps Jan-March results are terrible. In conclusion, net income is an attempt at giving what you want: an accurate representation of the health of a company in terms of what is under management control. However it may be inaccurate due to various factors, from malfeasance to incompetence.  That's why other financial measures exist - as another way to answer the same question about a company's health, to see if those answers agree. ex: Say net income is $10M this year, but was only $6M last year - great, it went up by $4M! But now assume that Accounts Receivable shows $7M owed to the company at Dec 31, when last year there was only $1M owed to the company. That might imply that there are problems collecting on that additional revenue (perhaps revenue was recorded prematurely, or perhaps they sold to customers who went bankrupt).  Unfortunately there is no single number that you can use to see the whole company - different metrics must be used in conjunction to get a clear picture."
Revenue is not profit. The *vast* majority of that revenue goes to the rest of the value chain of the products (manufacturers &amp; distributors). [Wal-Mart's profit margin is 3.77% of revenue](http://finance.yahoo.com/q/ks?s=WMT).  It's like saying VISA gets all the hundreds of billions of dollars people put on their credit cards, which is true, for a short period of time.  But if you dont want to do any critical thinking and just looking for confirmation of your beliefs, this infographic is great. :P "Yes, that's true, but notice what you've done here. You have given two reasons *why* ""management is unable or unwilling to spend on innovation that could generate future earnings to shareholders"". You have expanded on rather than contradicted the statement made by the authors of the article." Measures like GDP, unemployment, and wages are designed to measure the health of the economy.  Those are the right measures to look at.   When the economy is doing well, stock prices usually do well also, but not always.  The stock market went up 23% in 2009, and the economy was in the shitter.  And it shouldnt matter which newspaper published the numbers.  If the numbers are right, the numbers are right.  You dont need to hear GDP numbers on fox news to believe them. If there are idiots saying nasty things, they will say nasty things about your competitors as well. There will ALWAYS be unhappy people. However, if there are significantly more unhappy people for you than there are for a competitor, then they're not dumb - you are doing something wrong.  And you are right - you will sometimes disagree with the aggregate regarding relevant factors in judging a business. That happens, and there is currently nothing you can do about it. It does not diminish the value of the aggregate's opinion, though, for the vast majority of businesses. When you've been running your business without a profit for *11 years* (e.g. Tesla Motors), I would not call it a success. But maybe you happen to be very generous and think they should have another 11 to prove themselves. "Regardless of if the 'higher profits' are create from higher volumes and more workers, the key word there is PROFITS - not 'revenue', not 'income' or any similar word. PROFITS - a word used to describe the amount left AFTER paying expenses - such as the salaries of those additional workers (if any).  The point is, the worker deserve a share of those profits. It is their work that has made them - in addition to the work of the CEO, of course, but still...the CEO could not have created 'better margins' or done 'better deployment of capital' if it were not for the efforts of those workers in the first place.  This is the main problem with the economy right now. No one feels the responsibility to those who have helped them succeed. They keep using a 'slash and burn' financial strategy - slash salaries and benefits and burn up your labor force to extract every dollar you can for the top. The only problem is, now they're running out of things to slash and the workers they've burned have nothing left. And they wonder why the economy is in the crapper.  I keep being reminded of a quote from Ladyhawke as said by the evil bishop:   ""I raise their taxes, only to be told there's nothing left for me to tax. Imagine.""" You are correct. It's using accounting to accomplish different goals. First, relevant costs should be considered when making the decision to buy internally rather than externally. Second, by adding the possibility for a cost centre to turn a profit, even if it is only an accounting trick, means that interest are better aligned (profit motive and all). Third, you are right that on the consolidated/group level there is no real profit. It can give a better picture of actual economic performance though. "One of the very best case studies of the dangers of sacrificing product quality for profit, [Schlitz Brewing Company](http://en.wikipedia.org/wiki/Joseph_Schlitz_Brewing_Company) was [on the fortune 500 at one time](http://money.cnn.com/magazines/fortune/fortune500_archive/snapshots/1969/3214.html). In the 70's, Schlitz management [decided to make some changes to their beer to increase profit margins.](http://www.beerconnoisseur.com/the-fall-of-schlitz) They changed the fermentation process to a faster one, started using corn syrup instead of malt, and used hop pellets instead of fresh hops. They used unusual additives to compensate, which under certain circumstances make the beer the consistency of ""snot."" Short-term profits went up, long-term customers stopped buying the beer.    But if you want more modern examples, here are three from the [full list of 2012 fortune 500 companies](http://money.cnn.com/magazines/fortune/fortune500/2012/full_list/):  * [Morgan Stanley](http://en.wikipedia.org/wiki/Morgan_Stanley#Controversies_and_lawsuits) - responsible for global economic crash, sold financial products to customers while quietly betting against them. * Bank of America - doubles interest rates on customers in good standing and now charges fees for everything, including talking to a teller. * General Motors - now builds cars with interiors made mostly of cheap plastic.  edit: fixed link" "Marketing, namely advertising (Facebook, Google ads, maybe magazines, etc.) Despite all the nice words about ""healthy, green, and socially responsible"", the business of this company (and many, many similar ones) is not ""providing information"". It's affiliate marketing - getting people to click through to retail sites and buy stuff, on which the company earns commissions (often they also get paid for registrations). In a very real sense, their product is customers. They sell paying customers to the retail sites, and before that, they basically have to buy ""raw customers"" through advertising. The times when you could rely on getting enough people to visit your website for free are largely over - there is too much competition for peoples' attention. They can only be profitable if they can get the raw customers cheap enough, and can convert enough of them to paying customers.  And this is really how it's talked about internally, in what is by now a highly organized industry: key performance measures are CPC (how much does it cost to get someone to come to your website), conversion rate (what percentage of visitors register) and ARPU (average revenue per user)." "The title of the submission you commented on is ""Antibiotic-Free Meat Business Is Booming, Thanks To Chipotle"".  If the first sentence of your comment is ""Simply put this has to stop.""  From that, I can only reasonably infer that you think Chipotle needs to stop using antibiotic-free meat, which seems like a strange position." "No no no no and no. Headline accuracy is VERY important. People don't read articles. That was true two decades ago, let alone in the web age.  The title could have easily read ""Survey of 2,000 US CEO's finds pay jump minimum Of 27 percent last year."" Accurate, still gets point across.  Your explanation really concerns me because it excuses lazy and/or salacious journalism." And again, not true. Ive been to literally hundreds of warehouses. The only ones with climate control are food storage warehouses that need to be below freezing, or amazon. No other company in my experience has the kind of systems in place to keep employees as comfortable as possible given the job.  As for medical care, the warehouses i know the most about require an active EMT or paramedic license for medical responders in the warehouse.  I remember the articles years ago about working conditions at Amazon, but ive not seen anything to prove those accusations, and ive seen plenty to convince me they either are no longer valid, or they never were in the first place There are those who would suggest that due to the Efficient Market Hypothesis, stocks are always fairly valued. Consider, if non-professional posters on SE (here) had a method that worked beyond random chance, everyone seeking such a method would soon know it. If everyone used that method, it would lose its advantage. In theory, this is how stocks' values remain rational.  That said, Williams %R is one such indicator. It can be seen in action on Yahoo finance -  In the end, I find such indicators far less useful than the news itself. BP oil spill - Did anyone believe that such a huge oil company wouldn't recover from that disaster? It recovered by nearly doubling from its bottom after that news. A chart of NFLX (Netflix) offers a similar news disaster, and recovery.  Both of these examples are not quantifiable, in my opinion, just gut reactions. A quick look at the company and answer to one question - Do I feel this company will recover? To be candid - in the 08/09 crash, I felt that way about Ford and GM. Ford returned 10X from the bottom, GM went through bankruptcy. That observation suggests another question, i.e. where is the line drawn between 'investing' and 'gambling'? My answer is that buying one stock hoping for its recovery is gambling. Being able to do this for 5-10 stocks, or one every few months, is investing. Where we’re going, we don’t need profits Twitter Facebook LinkedIn Print this page 15 SEPTEMBER 19, 2017 By: Alexandra Scaggs Simply put, earnings no longer reliably reflect changes in corporate value and are thus an inadequate driver of investment analysis. – Profs Feng Gu and Baruch Lev, in a paper for the CFA Institute’s Financial Analysts Journal Well then!  This idea challenges the very heart of traditional equity-market investment analysis. The authors point out that legendary stock-picker Benjamin Graham spent hundreds of pages of his 1962 book on analysing and predicting earnings and other quarterly metrics. Earnings prediction is still central to most sell-side analysis as well.  But if profits, EBITDA or sales were truly central for corporate valuation, wouldn’t markets punish regular loss-makers like Tesla and Amazon more severely? And wouldn’t there be a stronger return to predicting profits?  The returns to such predictions have diminished over time, according to the authors of the paper, which might help explain the persistent underperformance by active fund managers. While the professors commit a minor chart crime below by starting the Y-axis at 1.5 per cent, it seems notable that potential gains were lower during the 2009 downturn than during the dot-com bust:  The 30-year pattern of the gains from the earnings growth investment strategy is depicted in Figure 2. Again, the deterioration of gains from perfect growth prediction is evident. Clearly, the problem lies with reported earnings, not in the way investors use them. Simply put, earnings no longer reliably reflect changes in corporate value and are thus an inadequate driver of investment analysis.  The decline in profits’ importance can be explained by a fundamental change in the way companies create value, they say.  There are lots of names for the change: The information revolution, the rise of the knowledge economy, and so on. No matter what you call it, the idea is that modern production relies less on physical capital and more on intellectual capital.  Accounting and financial analysis methods have failed to adapt to this change, they say. For example, companies are required to expense R&amp;D and sales expenses immediately, while they can amortise expenses from capital investment and acquisitions (including intangibles) over time. They argue those rules penalise the important methods of modern value creation, since R&amp;D costs create lasting returns from new products and SG&amp;A expenses create lasting returns from new customers.  Of course, one person’s “internally generated intangibles” can be another’s “overpaid salesforce”. But the difference in accounting treatment between those costs and acquired intangibles can make it difficult to compare within industries:  Thus, a company pursuing an innovation strategy based on acquisitions will appear more profitable and asset rich than a similar enterprise developing its innovations internally. Consequently, reported earnings, assets, and market multiples (P/E, book-to-market ratio) cannot be compared within industries, and earnings definitely do not reflect intrinsic value creation. And as far as we can tell, the professors aren’t lobbying to start amortising all sales costs and executive compensation. Instead, they say we should stop looking at the consequences of corporate value creation — the quarterly reports — and start looking at its causes.  They suggest financial analysis based on strategic assets, which are (1) rare, (2) difficult to imitate and (3) generate net benefits, like growth in a customer base or sales.  There would be four steps to this type of analysis. From the paper, with our emphasis:  1. Taking inventory of strategic assets: Compiling a list of the major strategic assets of the enterprise; distinguishing between operating and dormant assets (e.g., patents under development or licensed out versus abandoned patents), active brands (enabling the charging of a premium product price) and brands in name only, or producing oil and gas properties and those under exploration versus inactive properties. Such inventory taking establishes the foundation—active strategic assets—of the company’s competitive advantage. 2. Enhancing strategic assets: Without continued investment and replenishment, even highly productive assets will wither on the vine (recall Dell). You should ask, Is the spending on R&amp;D, technology purchases, customer acquisition, brand support, and employee training sufficient to maintain and grow the business? Cutting R&amp;D or employee training to “make the numbers” clearly bodes ill for future growth. 3. Defending strategic assets: These assets are vulnerable to competition (from similar products), infringement, and technological disruption, raising the question of whether the company’s assets are adequately protected by continuous innovation, patent defensive walls, and litigation. A continuous loss of market share clearly indicates a failure to protect assets. 4. Asset deployment and value creation: Are the strategic assets, along with other company resources, optimally deployed to create value (e.g., retail outlets with increasing same-store sales)? And what is this value? Note that in our analysis, the measurement of the periodic value created is a byproduct rather than the focus of the analysis. We prefer to measure value created by cash flows to avoid the multiple managerial estimates embedded in earnings. In contrast to the cash flows generally used by analysts (EBITDA), however, we add to cash flows the company’s investments in value-creating strategic assets, such as R&amp;D, IT, and unusual brand creation expenditures, which are not really operating cash outflows. Now, if we are living in a period of secular stagnation, this could be seen as an attempt to lower the bar to make up for lackluster capital investment. (One academic literature review we found on the topic of strategic assets only cites papers from around the time of the dot-com bubble. Fancy that!)  What’s more, “defending strategic assets” can sound a lot like “maintaining monopoly power”, depending on the methods companies use in their defence. So an investment analysis focussed on strategic assets might also require more aggressive anti-trust regulation.  But if you accept the idea that widespread adoption of the internet brought a fundamental and irreversible change in the drivers of growth, there are worse approaches to financial analysis you can take.  There’s more detail and argument in the paper, which you can find here. "Although I only cited product quality, I'm trying to think of examples of companies that incorporated and then immediately improved product quality, fostered good will, and treated its employees better than when they were private. None come to mind, can you think of any?  Perhaps ""almost always"" was a bit of hyperbole, but in matters of cost vs. quality I'd expect publicly traded companies to prioritize short-term shareholder profit (or be sued by said shareholders.) Private companies can have more of a vested interest in the good will of their employees, product quality, and can make decisions that benefit themselves and society long-term because they do not have this fiduciary responsibility.   Have you ever seen the documentary [*the Corporation*](http://www.thecorporation.com/index.cfm?page_id=46)? They make a compelling case that if corporations were people they'd be sociopaths (according to the ASM.)"