The Psychology of Money – My Highlights

Last month I read ‘The Psychology of Money’ by Morgan Housel. These are the highlights I made.

On idols and role models and following their paths

Therefore, focus less on specific individuals and case studies and more on broad patterns. Studying a specific person can be dangerous because we tend to study extreme examples—the billionaires, the CEOs, or the massive failures that dominate the news—and extreme examples are often the least applicable to other situations, given their complexity. The more extreme the outcome, the less likely you can apply its lessons to your own life, because the more likely the outcome was influenced by extreme ends of luck or risk.

On risk

There is no reason to risk what you have and need for what you don’t have and don’t need.

How random/chance events can shape your world

A tilt of the Earth’s hemispheres caused ravenous winters cold enough to turn the planet into ice. But a Russian meteorologist named Wladimir Köppen dug deeper into Milanković’s work and discovered a fascinating nuance. Moderately cool summers, not cold winters, were the icy culprit. It begins when a summer never gets warm enough to melt the previous winter’s snow. The leftover ice base makes it easier for snow to accumulate the following winter, which increases the odds of snow sticking around in the following summer, which attracts even more accumulation the following winter. Perpetual snow reflects more of the sun’s rays, which exacerbates cooling, which brings more snowfall, and on and on. Within a few hundred years a seasonal snowpack grows into a continental ice sheet, and you’re off to the races. The same thing happens in reverse. An orbital tilt letting more sunlight in melts more of the winter snowpack, which reflects less light the following years, which increases temperatures, which prevents more snow the next year, and so on. That’s the cycle. The amazing thing here is how big something can grow from a relatively small change in conditions. You start with a thin layer of snow left over from a cool summer that no one would think anything of and then, in a geological blink of an eye, the entire Earth is covered in miles-thick ice. As glaciologist Gwen Schultz put it: “It is not necessarily the amount of snow that causes ice sheets but the fact that snow, however little, lasts.” The big takeaway from ice ages is that you don’t need tremendous force to create tremendous results.

How avoiding bad decisions can help you succeed

Good investing is not necessarily about making good decisions. It’s about consistently not screwing up.

No one wants to hold cash during a bull market. They want to own assets that go up a lot. You look and feel conservative holding cash during a bull market, because you become acutely aware of how much return you’re giving up by not owning the good stuff. Say cash earns 1% and stocks return 10% a year. That 9% gap will gnaw at you every day. But if that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year—it could be many multiples of that, because preventing one desperate, ill-timed stock sale can do more for your lifetime returns than picking dozens of big-time winners.

Difference between becoming rich and staying rich

40% of companies successful enough to become publicly traded lost effectively all of their value over time. The Forbes 400 list of richest Americans has, on average, roughly 20% turnover per decade for causes that don’t have to do with death or transferring money to another family member. Capitalism is hard. But part of the reason this happens is because getting money and keeping money are two different skills. Getting money requires taking risks, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires humility, and fear that what you’ve made can be taken away from you just as fast. It requires frugality and an acceptance that at least some of what you’ve made is attributable to luck, so past success can’t be relied upon to repeat indefinitely.

Only the paranoid survive

A mindset that can be paranoid and optimistic at the same time is hard to maintain, because seeing things as black or white takes less effort than accepting nuance. But you need short-term paranoia to keep you alive long enough to exploit long-term optimism.

What is true freedom? How does money help achieve that?

Controlling your time is the highest dividend money pays.

But if there’s a common denominator in happiness—a universal fuel of joy—it’s that people want to control their lives. The ability to do what you want, when you want, with who you want, for as long as you want, is priceless. It is the highest dividend money pays.

Having a strong sense of controlling one’s life is a more dependable predictor of positive feelings of wellbeing than any of the objective conditions of life we have considered.

But doing something you love on a schedule you can’t control can feel the same as doing something you hate. There is a name for this feeling. Psychologists call it reactance. Jonah Berger, a marketing professor at the University of Pennsylvania, summed it up well: People like to feel like they’re in control—in the drivers’ seat. When we try to get them to do something, they feel disempowered. Rather than feeling like they made the choice, they feel like we made it for them. So they say no or do something else, even when they might have originally been happy to go along.

Understanding what you are paid to do

John D. Rockefeller was one of the most successful businessmen of all time. He was also a recluse, spending most of his time by himself. He rarely spoke, deliberately making himself inaccessible and staying quiet when you caught his attention. A refinery worker who occasionally had Rockefeller’s ear once remarked: “He lets everybody else talk, while he sits back and says nothing.” When asked about his silence during meetings, Rockefeller often recited a poem:

A wise old owl lived in an oak,
The more he saw the less he spoke,
The less he spoke, the more he heard,

Why aren’t we all like that wise old bird? Rockefeller was a strange guy. But he figured out something that now applies to tens of millions of workers. Rockefeller’s job wasn’t to drill wells, load trains, or move barrels. It was to think and make good decisions. Rockefeller’s product—his deliverable—wasn’t what he did with his hands, or even his words. It was what he figured out inside his head. So that’s where he spent most of his time and energy. Despite sitting quietly most of the day in what might have looked like free time or leisure hours to most people, he was constantly working in his mind, thinking problems through.

Do you really want expensive cars and watches or do you want respect?

The letter I wrote after my son was born said, “You might think you want an expensive car, a fancy watch, and a huge house. But I’m telling you, you don’t. What you want is respect and admiration from other people, and you think having expensive stuff will bring it. It almost never does—especially from the people you want to respect and admire you.”

Returns vs Savings

The first idea—simple, but easy to overlook—is that building wealth has little to do with your income or investment returns, and lots to do with your savings rate. A quick story about the power of efficiency. In the 1970s the world looked like it was running out of oil. The calculation wasn’t hard: The global economy used a lot of oil, the global economy was growing, and the amount of oil we could drill couldn’t keep up. We didn’t run out of oil, thank goodness. But that wasn’t just because we found more oil, or even got better at taking it out of the ground. The biggest reason we overcame the oil crisis is because we started building cars, factories, and homes that are more energy efficient than they used to be. The United States uses 60% less energy per dollar of GDP today than it did in 1950. The average miles per gallon of all vehicles on the road has doubled since 1975. A 1989 Ford Taurus (sedan) averaged 18.0 MPG. A 2019 Chevy Suburban (absurdly large SUV) averages 18.1 MPG. The world grew its “energy wealth” not by increasing the energy it had, but by decreasing the energy it needed.

How can you stand out in today’s world?

A question you should ask as the range of your competition expands is, “How do I stand out?” “I’m smart” is increasingly a bad answer to that question, because there are a lot of smart people in the world. Almost 600 people ace the SATs each year. Another 7,000 come within a handful of points. In a winner-take-all and globalized world these kinds of people are increasingly your direct competitors.

Intelligence is not a reliable advantage in a world that’s become as connected as ours has. But flexibility is. In a world where intelligence is hyper-competitive and many previous technical skills have become automated, competitive advantages tilt toward nuanced and soft skills—like communication, empathy, and, perhaps most of all, flexibility. If you have flexibility you can wait for good opportunities, both in your career and for your investments. You’ll have a better chance of being able to learn a new skill when it’s necessary. You’ll feel less urgency to chase competitors who can do things you can’t, and have more leeway to find your passion and your niche at your own pace. You can find a new routine, a slower pace, and think about life with a different set of assumptions. The ability to do those things when most others can’t is one of the few things that will set you apart in a world where intelligence is no longer a sustainable advantage. Having more control over your time and options is becoming one of the most valuable currencies in the world.

Spreadsheets vs real world

One is volatility. Can you survive your assets declining by 30%? On a spreadsheet, maybe yes—in terms of actually paying your bills and staying cash-flow positive. But what about mentally? It is easy to underestimate what a 30% decline does to your psyche. Your confidence may become shot at the very moment opportunity is at its highest. You—or your spouse—may decide it’s time for a new plan, or new career. I know several investors who quit after losses because they were exhausted. Physically exhausted. Spreadsheets are good at telling you when the numbers do or don’t add up. They’re not good at modeling how you’ll feel when you tuck your kids in at night wondering if the investment decisions you’ve made were a mistake that will hurt their future. Having a gap between what you can technically endure versus what’s emotionally possible is an overlooked version of room for error.

Other relevant lines

Napoleon’s definition of a military genius was, “The man who can do the average thing when all those around him are going crazy.”

“It’s not whether you’re right or wrong that’s important,” George Soros once said, “but how much money you make when you’re right and how much you lose when you’re wrong.” You can be wrong half the time and still make a fortune.

India and The 10 Rules of Successful Nations

What will it take for India to succeed? When will we shed the tag of emerging nation and graduate to developed nation status? Why is 28% of our population still poor? We explore these questions in detail in this article based on the book ‘The 10 Rules of Successful Nations’ by Ruchir Sharma.

The Covid Pandemic has thrown most plans out of the window. Before the pandemic, India was talking about becoming a $5 Trillion economy by 2025. While there were questions raised on the path to this goal even before the pandemic, the current struggle seems to be around how to get back to the pre-covid growth trajectory with the second wave and the many regional lockdowns. We are also seeing news of the wealthy and well-footed making plans to emigrate permanently amidst the collapsing health infrastructure of the country. In contrast, there are many who can afford to leave but are vowing to stay back and rebuild the country.

Before all these chaos began, any Indian who has ever visited a developed country and experienced their public infrastructure, transportation and health facilities would have wondered at least once, “When will India reach this level?” “What is stopping us?” Most people answer this question with one word Overpopulation. We are a nation of 1.3B people and unless we control our population growth we will always struggle. I wanted to understand this in depth and began reading up on what makes nations successful, the history of nations like South Korea and Japan that went from Emerging to Developed Nation status in a few decades and what is holding India back? There is no better place to start this journey than with the many books by Ruchir Sharma – ‘Breakout Nations’, ‘The Rise and Fall of Nations’ and ‘The 10 Rules of Successful Nations’.

Over the last few days I have been reading ‘The 10 Rules of Successful Nations’. Each chapter in the books lays down a rule and goes on to explain the same with the help of supporting data. I decided to evaluate India’s performance across these 10 rules to understand where we are doing well and where we are faltering.

Rule #1 : Population – Successful nations fight demographic decline

Most productive age of a human being lies roughly between 15 – 64. Countries like Japan, Germany etc have a shrinking population in that age group. Bringing more women into workforce, increasing the retirement age to 70, encouraging couples to have more babies by providing subsidises, welcoming immigrants in this age group (especially students who are then allowed to continue working in the country), automation and adding robots to workforce are some of the things countries do to counter the threat of a shrinking working age population.

India is lucky in this regard. We have a huge population that falls in the productive age range of 15 – 64. We will continue to enjoy this advantage dubbed ‘the demographic dividend’ for around 37 years starting back in 2018.

Demographic Dividend and Successful Nations
Image courtesy – https://economictimes.indiatimes.com/news/economy/indicators/india-enters-37-year-period-of-demographic-dividend/articleshow/70324782.cms

Rule #2 : Politics – Successful Nations Rally behind a Reformer

Politics seems to follow a circle where a national crisis leads to reform which leads to good times which in turn leads to complacency and from there to another crisis. During times of crisis, nations tend to elect a reformer as their leader. More often than not these are fresh faces with a massive support base. The first terms of these leaders are filled with promise and action but by the second year of their second term they tend to stagnate unable to push big reforms. Democracies tend to fare well compared to autocracies with a reformer at the helm and politicians with massive support bases tend to do well compared to technocrats.

India seems to be following this rule to the T.

Rule #3 : Inequality – Successful Nations Produce Good Billionaires

Good billionaires come from industries that make products and services that increase productivity like technology, manufacturing, e-commerce and entertainment whereas Bad Billionaires come from rent seeking industries that mainly involve extracting resources from nature like mining, real estate, construction etc. Two metrics we can keep track in this case are % of wealth held by billionaires vs GDP and % split of Good and Bad Billionaires. The former should be less than 10% and the latter should be 75:25 for emerging countries.

The numbers for India are

Total Billionaire Wealth / GDP = 14%

Good Billionaire : Bad Billionaire = 71 : 29

In both these metrics we don’t score that bad.

Why should Total Billionaire Wealth not exceed 10% of GDP?

Any economy works when people spend money. The problem with the rich becoming richer is that there is only so much money one can spend on food, clothing, appliances etc.

How does the rich keep getting richer?

Money introduced into the system by stimulus programs announced by governments during downturns, low interest rates etc aimed at increasing productive investments instead ends up getting diverted to purchasing stocks, luxury homes and other financial assets pushing up their prices. Most of these assets are owned by rich people and hence they end up getting richer. it is not the poor getting poorer but the rich getting richer that widens the gap.

Rule #4 : State Power – Successful Nations have Right-Sized Governments

A right sized government for a country like India is one whose spending is around 31% of the GDP. This spending should also go to productive investments for the economy to keep growing at a healthy pace. The ideal budget deficit should not exceed 3% of the GDP. While over spending is bad, underspending is equally bad. Underspending leads to creation of a black economy in the country. Once the black economy is a certain percentage of the GDP the tax revenue of the government drop as people avoid banks.

In India the government spending as a % of GDP stands at around 17.7% for FY22 and the budget deficit is around 9.5% of GDP. While the government spending at 17.7% looks reasonable if we were to look at what the government is spending on we will come to the conclusion that most of the money goes into subsidies and schemes.

India Government Expenditure

 

India Government Expenditure

You can refer the linked PDF for more details – https://www.indiabudget.gov.in/doc/Budget_at_Glance/bag6.pdf

Rule #5 : Geography – Successful Nations Make the Most of Their Location

Location still matters in the Internet Age. Physicals goods amount to $18 trillion of global trade compared to $4 trillion of services. Being located near and around trade routes matter a lot. Countries that don’t actively work towards building this connectivity to global trade routes suffer. Equally important is to distribute the wealth thus amassed by port cities to other provinces in the interiors of the country. China is the master of this game building many ports along its coastline devoid of natural harbours. Income earned through export allows a nation to build factories and roads, import consumer goods without building up foreign debt.

When it comes to India the Trade as a % of GDP has been hovering around the 40% mark. This percentage is fine for countries like India with a huge domestic market.

What India doesn’t do well is in terms of spreading the wealth across the country. The biggest marker for this failure is the lack of metropolitan regions across the country. While China has around 100 cities with more than a million population (the threshold to qualify as a metropolitan region), India has just 50. This means that the bulk of the population is concentrated in the main metro cities because the bulk of the opportunities are limited to those cities.

Another marker is the absence of boomtowns or towns where the population went from around 2.5L to 10L in a few decades. While China has 19 such boomtowns, India has just two and that too were created when authorities redrew the local administrative maps.

Shipping Routes of the World. Created by London-based data visualisation studio Kiln and the UCL Energy Institute

Rule #6 : Investment – Successful Nations Invest Heavily, and Wisely

Economy grows strongly when investment is somewhere between 25 – 35% of GDP. Now the problem with investment is that you can invest in good things as well as bad things. Good things like technology, roads, ports and factories fuel growth. Bad investment binges in things like real estate and commodities don’t fuel growth or raise productivity. In fact when investment in real estate becomes 5% of GDP there is a good chance of a bubble burst following.

Going by this rule, India’s investments hover around the 30% GDP mark. But very little of that investment goes to manufacturing. Most of the factories in India are also in the Small and Medium categories as larger factories tend to attract more bureaucratic scrutiny.

Rule #7 : Inflation – Successful Nations Control the Real Inflation Threats

Inflation refers to the uncontrolled increase in prices of goods and services. It is denoted as a % increase from last years prices. For emerging economies inflation ideally is in the 4% range and for developed nations it is in the < 2% range. There are two ways to control inflation. One is by increasing competition in the market thereby forcing companies to maintain or reduce their prices. The second is by raising the interest rates as people are reluctant to borrow money at higher interest rates. The opposite of inflation is deflation where prices of goods continue to fall year after year. There are two kinds of deflation, the good one is created by advances in technology that lowers the labour and other costs involved in producing goods thereby reducing its price. Then there is the bad deflation caused by a shrinking demand amongst consumers.

Inflation is tracked by a metric called CPI or Consumer Price Index. To calculate CPI, you first choose a base year (t1) and figure out the cost of goods (p1) for that year. Then to find the CPI of a subsequent year (t2) when the prices are (p2), you use the formula

CPI = (p2)/(p1) * 100

CPI has been steadily increasing in India for the last many years.

India CPI
India Inflation %

Rule #8 : Currency – Successful Nations Feel Cheap

US Dollar is the most traded currency in the world. For this reason most countries hold bulk of their foreign exchange reserves in US Dollars. In the event a country’s currency under goes a rapid devaluation, the dollars from the reserve can be used to pay the various import bills. For countries doing a lot of exports it is in their best interests to keep the value of their currency low compared to dollar. This means 1 dollar can buy more goods in a country thus attracting more people to trade with you. Subsequently your dollar reserves also increase.

To know how much a country exports and how much it imports we look at the Current Account of the country. When the exports of a country is greater than its imports we have a Current Account Surplus and a Current Account Deficit in the opposite scenario. A deficit means the country is importing or consuming more than it is exporting or producing. This excess has to be funded by borrowing from abroad. If the Current Account Deficit of a country keeps growing for 4 continuous years and peaks at the 5th year above 5%, trouble follows. Foreign investors and even domestic investors will start fleeing as they lose confidence in the economy.


source: tradingeconomics.com – India Current Account Deficit

When we look at the Current Account data for India, at least for the past 10 years our Current Account Deficits have been dropping consistently settling to around -1.7% of GDP for Oct – Dec 2020 quarter as per RBI data. Running a Current Account Deficit is not all bad if the excess imports being made are in productive sectors. Importing plants and machinery for manufacturing, state of the art telecom equipments are examples of productive imports.

Rule #9 : Debt – Successful Nations Avoid Debt Mania and Phobia

When private sector debt grows faster than the GDP for 5 straight years, crisis follows. The pace of growth of debt is more important than the size of the debt. When government intervenes to save the economy it is usually done through assuming some of these private sector debts. They also come in the form of bail outs and write offs. When a 5 year increase in Private Debt to GDP goes beyond 40% an economic downturn is imminent.

Private Debt as % of Nominal GDP India

Debt mania is something India seems to have been successfully avoiding. But India has been plagued with a lack of private credit especially for small and medium businesses. This gap is estimated to be around the Rs. 25 Lakh Crore range.

Rule #10 : Hype – Successful Nations Rise outside the Spotlight

Success comes through hard work and hard work is often done in silence away from all the hype. By the time media hype comes around usually a nation might have already peaked in terms of success. It might very well be on its way down or regressing to the mean. Ruchir Sharma calls this the Cover Curse. By the time a story reaches the cover of Time or Newsweek, it’s dead. So it might be a good idea to look beyond magazine covers if you are looking for upcoming successful nations.

 

Business Valuation in 5 minutes

This is a 5-minute read on Business Valuation for Start-Up Founders  looking to understand the basic mechanism behind valuation.

Basics of Business Valuation

There are 3 common approaches for valuing a business

  1. Cost Approach – What is the cost to build a factory or what is the cost to build a new factory in place of an old one
  2. Market Approach – Compare with the valuation of listed companies in similar space or based on a private deal that has happened recently
  3. Discounted Cash Flow – Value derived by projecting the cash flows of a business into the future and getting the Present Value of these future cashflows

In any valuation exercise, a registered valuer will use at least 3 methods, assign weightage to the value attained through each method and arrive at a Fair Value.

In India, a valuation certificate can be issued only by a SEBI registered Category 1 Merchant Banker. Earlier this could be issued by Chartered Accountants as well but not anymore. Charges for the same can run from a lakh to even up to 15 lakhs depending on the size of your business and the valuation firm.

Before we get into the 3 most commonly used methods of valuation, we need to understand what a Valuation Multiple is.

Business Valuation Multiples

Valuation multiples are broadly of two types – Enterprise Value Multiples and Equity Value Multiples. If you are running a business, there are two common ways for you to raise money for it. You can either sell shares in your company to an investor or you can take a loan or debt from a bank. If you use both these methods to raise money there will be a certain portion of business owned by the Equity Investors and another portion owned by the Debt Investors. This means that at any point in time the total value of your business or the Enterprise Value is a sum of the Equity Value + Debt Value.

Enterprise Value = Net Debt + Equity Value

So, back to valuation multiples now. Common Enterprise Value (EV) multiples are EV/EBITDA, EV/Revenue, EV/EBIT. Common Equity Value (P) multiples are P/E, P/B, P/CF. To keep things simple we will look at EV/EBITDA and EV/Revenue multiples only for now.

You can go to Google Finance and Yahoo Finance to find out the values for these multiples for few companies to get a general sense of things.

Business Valuation Methods

Like we discussed earlier, a registered valuer will use at least 3 methods in the valuation exercise to arrive at the Fair Value of a business. The most commonly used methods are

  1. Comparable Companies Method
  2. Comparable Transactions Method or Precedent Transactions Method
  3. Discounted Cash Flow or DCF Method

Comparable Companies Method

If you were to value an e-commerce company you would choose companies like Amazon, eBay, Easy, Alibaba, etc as Comparable Companies. The valuation multiples for these companies are readily available online. We can calculate the Median of these values to arrive at the final multiples to be used for calculation.

For eg: If the median EV/Revenue multiple of the comparable companies is 6.5x and the Revenue for your business in the year where you turn profitable is Rs. 1,00,00,000. Then the EV = 10000000 * 6.5 = Rs. 6,50,00,000. Once you have the EV, you can subtract the net debt to arrive at the Equity Value of the business. 

Of course, this is simplifying things a little too much. To the multiple, we will have to apply various discount factors like a Small Company Discount as your business is much smaller compared to Amazon, a Lack of Marketability Discount etc.

Comparable Transactions Method

Now, let’s look at the Comparable Transactions Method. In this case we look at the various Private Deals that have happened in the industry and find out the valuation multiples at which those transactions happened. The math remains the same as above. Although it sounds pretty simple it is incredibly difficult to find private deals data that are relevant to your business.

Discounted Cash Flow (DCF) Method

Lastly we have the Discounted Cash Flow method. Unlike the other two methods here we use the financial projections of the business and hence arrive at the Intrinsic Value of the business. Financials projections are usually made out to around 5 years from current financial year and for each of the 5 years you arrive at the Free Cash Flow to the Firm. From these yearly Free Cash Flows (FCF) you calculate the Present Enterprise Value by assigning a discount factor to each years FCF.

For eg: If a Company X has FCF for Year 1 till 5 as Rs. 100, 200, 300, 400, 500, to calculate the Present Enterprise Value, we have to first find out the Discounting Factor for each of the years from Year 1 to 5. The formula for Discount Factor is

Discount Factor = 1/(1+Discount Rate)^Time Period

Discount Rate is essentially equal to the Weighted Average Cost of Capital or WACC and the formula for WACC is 

WACC = (Cost of Equity * % Equity) + (Cost of Debt * (1 – Tax Rate) * % Debt)

Cost of Equity = (Risk Free Rate + (Beta * Equity Risk Premium))

Cost of Debt = Avg. Yield on Debt

Risk Free Rate, Beta, Equity Risk Premium, Avg. Yield on Debt are values that change from country to country and Industry to Industry. So based on this data you can calculate your WACC and subsequently your Discount Rate and Discount Factor.

Once you calculate Discount Factor * FCF for each of the 5 years, you can sum up these to arrive at the Enterprise Value

Now you subtract the Net Debt from the Enterprise Value to find out the Equity Value

Equity Value = Enterprise Value – Net Debt

Now to find out the value of a single share you use the following formula

Value per share = Equity Value / Total No. of Shares

Fair Value

Once you have the Equity Value calculated with the three methods, you can assign weightage to the value obtained from each of the methods and arrive at a Fair Value of the Company. 

Further Reading on Business Valuation

As I mentioned in the intro this is a basic 5 minute read on the vast topic of Business Valuation. If you want resources which can help you get a deeper understanding on the topic you can take a look at the following

If you are looking to get into the details of calculation with proper numbers and all the above video will be helpful

If you are looking to understand how an expert in Valuation thinks, the above Talk by Prof. Aswath Damodaran will be helpful

If you really want to get your hands dirty then you can probably take the course on Business Valuation by the CFI Institute and maybe even get a certification. This is what I did.

 

Margins – how they can make or break your business

Gross Margins, Net Margins, Profit Margins, Operating Margins are few of the terms thrown around when we talk about the profitability of a business. What do they mean? Why are they important? In this post, I will try to cover these in very simple terms. If you are a start up founder looking to understand these terms then read on.

The Donut Business Margins

Let’s say you are running a donut business. To build a sustainable business you need to make profits. To make profits you need to know all your expenses and price the product appropriately. So what are the expenses involved in running a donut business?

There is the cost of ingredients needed to make donuts like flour, sugar et. Let’s call these the ‘Cost of Goods Sold

Then there is the expense of operating a store like rent, employee salary, electricity bill etc. Let’s call these the ‘Operating Expense’

What else? Well, if you had taken a loan out to set up this business, then there is the Interest you have to pay out for that. There is also the tax that you have to pay to the the government. Let’s club these under ‘Interest and Taxes’.

Now let’s say in a month you buy ingredients worth Rs. 1000 to make 100 donuts. This means your Cost of Goods Sold = Rs. 1000. 

Your rental, employee salary, electricity bill etc. comes around to Rs. 500 a month. So, Operating Expenses = Rs. 500.

The interest and tax expenses comes out to around Rs. 100 per month. So, Interest and Taxes = Rs. 100.

Adding all these expenses your monthly expense comes out to around Rs. 1600. So, by selling the 1000 donuts you need to make a minimum of Rs. 1600 or Rs. 1.6 per donut. At Rs. 1.6 a donut you are essentially at break even or no profit, no loss. 

Now if you want to expand your business you need more money. You can raise this money by getting a bank loan, approaching an investor or by raising the price of your donuts. So, if you were to raise the prices of donut by Rs. 0.4 you would now be selling donuts at Rs. 2.

Revenue

Rs. 2000

Rs. 2 / donut * 1000 donuts

Cost of Goods Sold (COGS)

Rs. 1000

Cost of ingredients

Gross Profit

Rs. 1000

Revenue – COGS

Operating Expenses

Rs. 500

Rent, Salary etc

Operating Profit

Rs. 500

Gross Profit – Operating Expenses

Interest & Taxes

Rs. 100

 

Net Profit

Rs. 400

Operating Profit – Interest & Taxes

Calculating Margins

Once you have the above values you can calculate the margins with the following formulas

Gross Margin = (Gross Profit/Revenue) x 100%

Operating Margin = (Operating Profit/Revenue) x 100%

Net Profit Margin = (Net Profit/Revenue) x 100%

From the above calculations we can understand that higher gross margins ensure that you have more money left to spend on sales, marketing, rentals and employee salaries after paying for the raw materials cost. But not all industries work on high gross margins. Industries dealing with physical goods usually have low gross margins as it involves a higher Cost of Goods component. Industries dealing with digital goods, financial services etc have higher gross margins as there is 0 or very low Cost of Goods component.

Business Moats

So naturally for low gross margin businesses the key lies in volumes and the size of transactions. Slight variations in any of the two can send these businesses to a tail spin. Low gross margin business that survive for a long period of time usually develops a defensive moat around them. These can be 

  1. Network Effect Moats – eg: Any social media network becomes more useful as more and more of your friends join it. This is the moat that Facebook, Twitter etc take advantage of
  2. Cost Moats – eg: Switching Costs – If your company has been using Amazon Web Services there is cost involved in moving to Microsoft Azure or Google Cloud
  3. Cultural Moats – eg: Brands like Patagonia, Starbucks etc have huge brand value which makes it difficult to beat these brands
  4. Resource Moats – eg: Pharmaceutical companies like Pfizer own many IPs, patents etc which makes it difficult for upstarts to compete with them

In über competitive spaces companies are willing to work on negative margins as long as they can raise external funding and drive out the competition in the area. Post that they can raise their prices to become profitable. Most of the heavily funded start ups deploy this strategy as this is the easiest to implement. So in the donut example, if some one was selling donuts for Rs. 1.2 you will obviously have to sell it at 1.2 or lower to compete provided that the donuts are of the same standards. Who will blink first depends on who has the deepest pockets.

Further reading on business margins

 

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