Management, Profitability and Effectiveness
Management
Often times you’ll hear investment gurus talk about a company’s management. We believe the quality of a company’s management is very difficult to assess. How do you tell if a CEO is great at running a company? It the company’s success all his doing or is it the people below him? Usually these are difficult questions to answer. Instead of answering these questions, at StockBoxFinancial we look at different questions and statistics to help us assess the management of a company. First we look at the SEC filing 14A, the proxy statement. This form gives you a summary of all the executives and board members. From this statement you can judge experience and the depth of management. Also, on this form you will find the holdings of executives and the board members. Insider ownership (stock held by employees and executives of a company) is a major tool for investors. If insider ownership is high then management’s interests will coincide with shareholders’ and everyone will be better off in the long run. If you don’t want to look sludge through the 14A filing then you can always just check out the level of insider ownership on Yahoo Finance under the “key statistics” tab.
Profitability and Effectiveness
There are as many formulas to measure profitability and management effectiveness as there publicly traded stocks. The proper tool usually varies in different industries. An amateur’s edge will be particularly helpful in this case. If you don’t have an amateur’s edge, then look at what management uses in the annual report.
The most common tool for measuring profitability is the profit margin. The profit margin is simply the net income divided by sales expressed as a percentage. So, if ABC Inc. makes a profit of $10 on $100 of sales then its profit margin is 10% or 0.1 (10/100). A lot of times the profit margin shows the competitive strength of a company. Investors usually look for companies that have profit margins that are greater than industry averages.
What a company is doing to maintain or increase its profit margin is almost more important then the size of the margin. If a company can increase its profit margin it can increase income by selling the same amount of stuff. If you find a company that can increase its profit margin while increasing sales you may have a pretty explosive stock on your hands.
There are many different variations of the profit margin, but the basic idea is the same. If you hear some variation of profit margin you can look it up at investopedia.com.
It is important to not that some companies keep their profit margins artificially low for competitive reasons. For example, some firms keep their profit margins artificially low in order to gain market share.
A metric used by analysts to measure management effectiveness is Return on Equity (ROE). ROE is the return generated by company on the money that shareholders have invested. ROE equals Net Income divided by shareholder’s value or equity. Similarly to the profit margin, there are many different ways to calculate ROE. If you ever come across a version you don’t understand just look it up on investopedia.com.
Depending on the industry, investors use profit margins or ROE or both in evaluating a company. The best place to determine which metrics to use is to look in the annual report.