Investment questions - part 2

Questions about the operations of a company have been discussed in an article which was published earlier. With the answers on the questions mentioned in that article, you can make a general overview of the company. Besides the general information, it is important for investors to know the financial situation of a company, especially the profit and cash flow. In this article, profit and cash flow questions are discussed.

From where must the future growth of profits come from?

The stockprices of a company are (partly) based on the future profits of the company. This is the reason why questions about profits are the most important questions an investor could pose when investigating a company. Possibilities for growth of the profits are, among others:

  • Geographical extension, for example to China or other countries in the developing world;
  • Taking market share from competitors, for example by lowering prices (but still make a profit);
  • Develop new products in existing markets or enter new markets with existing products;
  • Cheaper and more efficient production, less costs means a higher possible profit;
  • Pull up the prices of existing products and existing markets, without losing market share. This is prove of a strong market position;
  • Acquisitions which directly add to profit.

How well did the company performed in the past?

Investors incline to avoid the company if management has disappointed the investors by showing uncertain financial figures or inclearness within the company. Even more so when analysts and media posed negative statements about the company. After a while it might be interesting to take a look at the company, because all possible bad news is discounted in the company's share and the sentiment can change. Above all: if stable profits are published, the bad period will be forgotten soon.

Has the company ever suffered a loss?

When a company has suffered a loss in a year in the (near) past, this can happen again. Off course every company can suffer a loss, but at companies that have had losses in the near past it is more likely that this will happen again. Because making a profit is less certain at these companies, the price to earnings ratio will be lower than the mean price to earnings ratio of the industry.

Does the profit fluctuates a lot?

When the profits of a company strongly moves up- and down, the price that the investors pay, will be lower (so the price to earnings ratio will be lower). As an investor, you never know whether the company will make any profit in the next year. Cyclical companies are examples at which the profit fluctuates a lot, just like start-ups. Cyclical companies often have high fixed costs, mainly caused by large investments (e.g. factories). Besides that, the volume, and also the sales prices, strongly depends on the economical situation. Start-ups often depend on a few (large) customers, so when a new customer orders, or an existing customer walks away, this will have a major impact on the profits.

What is the quality of the profit?

The quality of the profit means the certainty of the level of the profit of a company. If the profits depend on a one-time event, or the company benefits from something that is cannot be influenced by the company, the quality of that part of the profit is low.

It is possible that the profit has increased, just because the company has a lower tax rate, for whatever reason. The profits can also be increased by lowering the depreciation or some special income (like selling parts of the company). Both examples result in a lower quality of the profit.

Does the profits depends on a few large customers?

When a company depends on a few large customers, who may suddenly walk away or go bankrupt, the company may be faced with a substantial decline in profits. This increases the risk of investing in such a company. As discussed earlier, start-ups often depend on a few companies. But also large companies may depend on a few customers who are accountable for a large turnover. Heavy industry is a sector at which most companies typically compete for a few large customers. Smaller customers can exist in these industries, but the sales to those customers are practically nothing compared to the large companies.

How does the change of government and politicians affect profits?

Some companies make a lot of profit, just because some rules and laws. The healthcare industry is an example of an industry which is highly regulated. Also companies can make a higher profit because of tax benefits and environmental measures. These benefits can disappear when the governments change or some measure reach the end of their life. Politicians do not have profits of companies high on their priority lists. So the profit that companies make because of rules and laws, must be seen as temporarily. At the other side, new rules and laws can positively influence the profits of a company.

How does the profit of a company react on currency exchange rates?

When a company realizes a large part of its turnover and profits in a foreign country with another currency, changes in exchange rates will affect profits. A company can even get in trouble when the exchange rates move too much to the wrong side. In certain industries it is common to use one currency all over the world, like the US dollar in the oil industry. Within an industry, changing exchange rates can cause losses for one company, while the other company that operates in another country, benefits from the changes.

Does the weather affect the profits?

Some companies depend on the weather for their operating or sales. Examples are manufacturers of ice creams, utility companies (energy) and breweries. Although the weather can influence the profits of a company, it is often exaggerated, simply because people understand the influence of the weather on a certain company.