If you own shares in a company, here's a question you should be able to answer: how much profit is your company making?
Don't worry. This is not a trick question. There is no catch. It's just that most people think companies are more profitable than they really are.
Three experts who have studied the matter are Hermann Simon, Frank Bilstein and Frank Luby. In their book, Manage for Profit, Not for Market Share, they write: "Ask the person on the street how much profit a typical company earns on $100 in sales, and most answers will fall between 25 and 50 per cent."
Unfortunately, as they rather gloomily observe, "Nothing could be further from the truth. The real aggregate profit margins of companies in most developed industrial countries lie dangerously close to zero."
Take Wal-Mart, for example. Every year, according to Charles Fishman, author of The Wal-Mart Effect, 93 out of 100 American households shop at Wal-Mart. If 100 per cent were to do so, each would spend a little over $2,000. Guess how much of that Wal-Mart would get to keep as profit: a grand total of $75. Admittedly, profit margins are notoriously thin in Wal-Mart's line of business. Still, you may find 75 out of 2,000 quite startling. If so, you are not alone.
Doing the arithmetic of corporate profits is easy. The next time you get an annual report, go straight to the profit and loss account. Look for the line that says 'profit after tax'.
This is the amount left with the company after it has paid for everything it needs to stay in business, including tax and interest on loans. If you are comparing companies, divide this number by the company's sales for that year. (The sales number is even easier to find; it's the first number on the page.) What you have, profit divided by sales, presented as a percentage, is the company's profit margin.
From time to time, you may have to apply a modicum of judgement. Companies sometimes classify certain costs as 'extra-ordinary items'. If there were any in the year you are examining, there will be a note explaining them. It is up to you to keep delving until you have a feel for how the company is faring.
Whether or not you ultimately agree with the company's accounting decisions, if you go about your investigation diligently, you are sure to emerge with a better grasp of the company's fortunes.
Once you have some idea of how profitable your company is, find the number of shares outstanding. This usually appears in the notes accompanying the profit & loss account. Divide profits by the number of shares to get the earnings per share. Divide that by the share price and you have a useful yardstick: earnings yield (or, if you find it easier the other way, its reciprocal, the rather more famous price-to-earnings ratio).
You can now compare very different companies: A, which earns Rs 6 and has a share price of Rs100, yielding 6 per cent, and B, which earns Rs 3 and has a share price of Rs 30, yielding 10 per cent.
The rest, one might say, is security analysis. If you find you have a taste for this sort of thing, there is no dearth of books to help you sharpen your skills. (Security Analysis by Benjamin Graham and David Dodd is the classic).
But even if you'd rather not devote your life to the subject, pick up a pencil the next time you leaf through an annual report. A few quick sums will stand you in good stead.Next time the market does something strange, you'll find it easier to judge the prices being quoted for companies that interest you -- and, unlike other people, you won't tend to over-estimate the profits those companies make.