Case Study for Chapter 1
A. A good business, according to Buffet and his colleague Charlie Munger, is one with the following attributes: simplicity, high return rates on the invested capital, substantial profit margins on sales, has pricing flexibility, high cash flow, high ROE, strong franchises and owner-oriented management, and consistent earnings growth that are immune to natural targets of regulation (Hirschey, 2008).
A good business is simple in that it is not only easily understood by customers and other stakeholders, but also is easy to manage. For instance, if lots of technology is involved in the business, it would not be fully understood and, therefore, appeal to less distributors (Hirschey, 2008).
Strong Business Franchises
Buffet observes that a good business has strong business franchises where it reaps benefits from the economic goodwill (Hirschey, 2008). Such business has flexibility of pricing, which alludes to the ability to raise its prices above the level of inflation.
A business can be termed good when its earnings can confidently be predicted into the near future (Hirschey, 2008).
High Returns on Capital
A good business is able to put incremental capital to achieve above average return for a long time (Hirschey, 2008). It achieves this without engaging in creative accounting or becoming excessively indebted. Therefore, the price charged for products need to be substantially higher than unit costs.
Strong Cash Generation
A good business generates enough cash and does not need heavy reinvestment in assets so to remain relevant in the market. This way shareholders are saved from the trouble of investing extra dividends they deserve to receive (Hirschey, 2008). The business is thus able to invest its cash in other areas, which brings even more profits.
B. Coca Cola Company, Gillette,, Well Fargo & Company, and the American Express Company are some of corporate giants with significant stock holdings in Berkshire Hathaway, Inc. All major holdings of Berkshire Hathaway are large capital-intensive companies having rich operating record of above-average rates of return. Being examples of good businesses, Berkshire’s major stock holders consistently demonstrate excellent utilization of assets as evidenced by their average ROE, which is way above typical norm (Hirschey, 2008). Furthermore, these companies are attractive in the sense that they post above-average annual rates of growth, especially in stockholders’ equity. As such, they can all be termed beneficiaries of high-margin growth. More often than not, all of these companies display attractive operating and financial statistics.
Coca-Cola Company, Berkshire’s largest and most successful holding, has the world’s strongest franchise, both projectable and growing returns, and strong owner-oriented management, besides being immune to price or profit regulations (Hirschey, 2008). Similarly, the American Express Company is a premier travel and financial services company strategically positioned to appeal to aging baby boomers . The Wells Fargo & Company and the Washington Post Company also fit in definition of good businesses because they translate large economies of scale of production into their respective competitive advantage. Gillette’s above-norm returns come from their unique products that are designed and produced by extraordinarily capable management.
C. Buying common stock in well-doing large corporations such as Coca Cola, Wells Fargo & Company, and Gillette will always be a gamble for the investor. This is especially true because the investor is at the mercy of time to tell whether he/she made an appropriate decision in the first place, regardless of predictability of firm’s performance. Above-norm returns following investment in wonderful business is only achievable to the degree that other investors cannot fully recognize such advantages. However, it is also possible to reap high returns from investing in stocks of good companies that experience some significant, yet fixable problems (Hirschey, 2008).
As such, above-average stock market returns in the long-term (in this case three years) would indicate a correct investment decision. This means that stocks pay higher yields relative to the overall market. Thus, the most typical measure of stock’s worth is based on company’s earnings, sales, debt, and equity aspects.
Case Study 2: Profitability Effects of Firm Size for DJIA Companies
A. There is high correlation between firm size and profitability as evidenced from the results of DJIA corporate giants. Statistically-important size coefficient in profit = f (sales) correlation suggest that profits grow with sales revenue. Likewise, statistically-important size coefficient in profit = f (net worth) relation proves that profits increase with the amount of capital invested, as measured by book value of stockholders’ equity. However, these results do not imply competitive advantage of these giant corporations stems from their large firm size. Therefore, there is no strong correlation between large firm size within the DJIA and their profit rates. While large firms make big profits, there is no evidence to prove that large firms earn big profits (Hirschey, 2008).
B. For large DJIA firms such as Wal-Mart, General Motors, and Exxon, there are varying profits and profits rates from year to year. Wal-Mart was able to attain high rate of return on stockholder’s equity regardless of their very low profit margins as well as low markups over cost (Hirschey, 2008). The company has been able to attain superior profitability because of wide selection of products and low prices offered in Wal-Mart’s convenient stores.
Being a large oil company, Exxon’s profitability is dependent on global price of oil that is revised by the OPEC from time to time. While investors have found it problematic to keep up with market averages, Exxon’s profit rates have been high and compare favorably with other large corporations such as GM.
Merck is renowned for manufacturing effective and innovative drug therapies year after year, while Proctor & Gamble is an example of a firm that earns huge profits from developing and promoting valuable consumer products. Coca Cola has been profitable for the longest time because of aggressive marketing strategies for its beverage products. Generally, large firms known for high profit rates have a record of unmatched product development and outstanding customer services.
C. There are several other significant factors that can be taken into consideration in a more detailed study pertaining to determinants of corporate profitability. First, rapid firm growth often results in increased profitability over time. Likewise, variable such as advertising and R expenditures result in more current and future profits for the firm (Hirschey, 2008). Given that profitability varies from industry to industry, it would also help to consider the impact of other factors, such as the size and number of distributors, tax rates, and environmental regulations.
United Arab Emirates can create economic demand and supply in its economy through the following measures: building an open, effective, efficient and globally-integrated business environment; adopting disciplined fiscal policies which are responsive to the economic cycles; introducing a resilient monetary and financial market atmosphere with manageable levels of inflation; undertaking major improvement in efficiency of labor market; developing a resilient and sufficient infrastructure that is capable of supporting expected economic growth; developing a highly skilled and productive workforce; and enabling financial markets to grow into major financiers of its economic sectors and projects.
Market size research along with product-specific information is used to predict success for a new product. Combining macroeconomic trend information with information pertaining to microeconomic and competitive performance is a useful approach. A customer will purchase a new product when he has a need to do so and is able to afford it. Thus, purchasing power of the target group must be considering when introducing a new product. Also, advertising needs are an important consideration because potential consumers must be informed of the new product or service offering (Hirschey, 2008). Customers also judge new product on the basis of company’s brand reputation. Econometric models represent the relation between Y (the forecast value) with a series of independent X variables.
Revenue and profit data posted by FedEx Corp. and United Parcel Inc. provide useful information regarding trends in the entire economy given that paced of shipped goods is a key indicator of future sales. FedEx and UPS give first priority to sales revenues of leading manufacturers before stockholders, whose goods are in shipment. Typically, sales and profit figures increase for shippers before sales and profit figures related to shipped are included in audited financial statements of manufacturers.
Therefore, when large industry players such as FedEx or UPS show high profit levels in a given quarter, it signals a possible positive outlook of the economy at present and in the near future (Hirschey, 2008).
Common expenses refer to expenses needed for manufacturing a joint product. Common cost of products (e.g. raw material, equipment costs, management expenses, other overhead) cannot be earmarked to each single by-product on an economically sound basis. It is only possible to allocate costs that can be individually identified and linked with a particular by-product (Hirschey, 2008). For instance, refrigeration costs for beef and cost for tanning hides are separable identifiable costs for each by-product. Allocation of such common costs is thus wrong and arbitrary.
Starting your own firm and venturing into business is indeed a capital budgeting decision. You only proceed if projected returns seem attractive both personally and financially. Capital budgeting is the process of planning expenditures, which generate cash flows that exceed one year, such as expenditures for land, equipment, buildings, new research, development programs, and advertising (Hirschey, 2008). The decision to venture into business equals a decision to fund capital budgeting project, where both monetary and nonmonetary benefits are key considerations. Given that it is unviable to fund a money-losing operation indefinitely, an individual-funded business must factor in out-of-pocket costs together with a desirable rate of return on investment. Own business offers great work flexibility and personal satisfaction.