Some years ago, I put together a simple profit margin forecasting formula. It ties margin analysis together in a quantitative fashion. The formula is intended to be more thought provoking than practical. No one formula could possibly explain all the different variables affecting margins. Mine certainly can’t. It won’t allow you to forecast margins precisely. Rather, it is useful because it raises questions about the future margin potential of a company.
The formula in its most reduced form is:
This formula’s utility may not be obvious. It is powerful and easy to use. It takes into account market share, relative market share, and growth rates. While it may look confusing at first, it is easy to compute.
Knowing market shares and growth rate, you can compute this formula on a calculator in seconds. The formula ignores the total number of industry participants because, if there are many industry participants, most will be marginal. If there are only a few industry participants, the economics will be covered by the formula. The formula assumes a constant tax rate of 50 percent.
Note the formula doesn’t allow for a 100 percent market share by any party. One hundred percent market share means no competitors. In the real world, monopolies don’t exist unless the government creates or regulates them. If they do, as in the case of
0.13(Market share) (1 Industry growth rate)2 +
M
Market share of largest competitor Average long-term potential margin =
149
Copyright © 1984 by Kenneth L. Fisher. Copyright © 2008 by The McGraw-Hill Companies, Inc. Click here for terms of use.
regulated utilities and the like, they don’t usually allow fat profit margins.
What would happen if your competitor has 100 percent market share? You must have no business and therefore can’t possibly make any margin. If your company has 100 percent market share, its monopoly position should allow an infinite profit margin. Logic would say this is possible. An economist would argue it isn’t likely.1
The formula allows for varying market shares and extremely rapid or negative growth rates. The coefficient of 0.13 is arbitrary and was determined by experimentation over time. A prime variable is the exact market and industry within which a company competes. This can be very difficult. What market does Federal Express exist in? What is its market share? In a multi-industry firm or a conglom- erate, it may be quite confusing also. Within a single industry, there are frequently a number of different markets. Markets may be defined, for example, geographically by freight-cost limitations (the cement industry, for instance), or socially (most prestige consumer items). A Kaypro Computer, the Volkswagen of its industry, really does not compete with the Mercedes-like Grid Systems Computer at six times the price. They just aren’t the same markets.
Some Examples
To test the theoretical validity of the formula, consider some examples. Suppose a company has a 30 percent market share in an industry you believe will grow at a 40 percent rate for the next five years. Its largest competitor has a 12 percent market share. The formula says the company has the potential for a 13.7 percent profit margin.
This company is in just about the most ideal position imaginable. It has a high and dominant market share in a rapidly
Potential margin 0.13(0.30)(0.30)(1 0.40) 0.
= +
112 = 0 137.
1Even most monopoly producers shouldn’t be able to get extraordinarily
high profit margins. Unless they are one of the few having an “extremely inelastic demand,” it would be impossible.
growing market where its largest competitor is less than half its size. Common sense points to good future prospects. (Fortunately, so does my formula.) If this company earns poor margins, it has tripped over itself in some regard. It likely failed to develop good strategies or to execute them well. The formula does not say the company will earn a 13.7 percent profit margin—rather that it has the potential to earn good profit margins if it tends its business properly (Company C in the previous chapter, with the assumption its industry grows quite rapidly).
Consider Company B from that same example. It has a 30 percent market share, as does its largest competitor. If you envi- sion a 5 percent growth rate, the formula shows it having the poten- tial for margins of only 4.1 percent. The formula places a heavy bias against the firm in a low- or slow-growth industry, even with a fairly high market share.
If a company is in a low-growth or declining industry and wants to achieve above-average profits, things are more difficult. It had better have some very unfair advantages. The average profitability of companies in the steel industry over recent years— even those with high market share—has been very poor. Nucor Corporation produces commodity steel: angle irons, re-bars, flat strips, channels, I-beams, and other structural shapes. These are commoditylike products with little or no growth prospects. Nucor started in the early 1970s with a very low market share. In spite of these disadvantages, it exploited several unfair advantages to achieve above-average profitability and growth.
This is the point of the formula: It allows an investor to focus on how much of an exceptional unfair advantage is necessary for a com- pany to achieve its margin goals. In Nucor’s case, the formula would say that low margins were all that was possible. While investigating Nucor, this placed all the emphasis on the magnitude and quality of the unfair advantages. Everything else became secondary.
Note the formula generates no negative numbers. Every business has the potential for profitability—regardless of market share, growth rates, or competition. Potential is different than
Potential margin= 0 13 0 30 0 30 1 0 0 05. ( . )( . )( . + . )
actualization. Companies lose money long term by failing to match their potential—not because they never had any.
Regardless of potential, companies must seek out advantages at every opportunity. Certainly the competition will. It also is important to consider competitors with respect to margins. What are their margins and what does that say about the company you are considering? Does the competition have some unfair advantage over “your” company? Virtually no firm will admit that competi- tion has serious advantages. This is where talking to customers, suppliers, and competition pays off in spades. The “Scuttlebutt” method, described in Common Stocks and Uncommon Profits (New York: Harper & Row, 1958), is a necessary step in learning the relative competitive situation:
What kind of margins do competitors achieve and why? If the competition gets very high margins, should the company you are considering also get good margins? Why? Perhaps competition has the “unfair advantage.”
This is an important point in the evaluation process. Once past this point, some simple rules help to approximate future margins.