Spot Industry Trends and lead your business toward success

Chia-Li Chien | Jan. 14, 2015

Three companies that J. Berr identifies, in 6 Brands That May Not Make It Through 2015, published in December 2013 [2] and 2014 [1] include:

• Radio Shack (NYSE:RSH)
• Sears Holdings (NASDAQ: SHLD)
• Martha Stewart Living Omnimedia (NYSE:MSO)

It’s really heart breaking and also, disturbing, to see companies listed as “brands in danger of disappearing.” At the same time, the article also identifies many outstanding companies [1] such as:

• Facebook, Inc. (NASDAQ: FB)
• Amazon.com Inc. (NASDAQ: AMZN)
• The Walt Disney Company (NYSE:DIS)
• Apple Inc. (NASDAQ:AAPL)
• Google Inc. (NASDAQ:GOOG)

Obviously, every business has a unique lifecycle. Some businesses thrive and adapt quickly as their industry evolves and the company trends along the way. There are many factors that determine whether a business will grow consistently or lose ground.

From a Financial Fundamental Analysis perspective, the trending of a major ratio is key in order for executives to act. The ability for an executive team to act quickly is critical to a company’s future. The company’s future may depend on certain actions either to correct the course to meet business goals or stay competitive with the industry. Key financial ratios can be spotted based on simple trending or forecasting.

Let’s compare and contrast a few key financial ratios and the trending over time. In the article referenced earlier, each company is identified based on its trading symbol listed above. (Data source is from Morningstar [3].)

The financial ratios I will compare are:

• Operating Margin %
• Free Cash Flow / Sales %
• Market Cap

To compare any company fairly, you must first compare it to your own industry benchmark—for example, FB compares to Internet Content & Information or RSH compares to Specialty Retail, etc. For simplicity, I will compare only among these companies mentioned here and not industry or S&P 500. I will look at the past 10 years performance of each company and illustrate the immediate last 5 years to see the trends.

Our purpose is to illustrate what the power of simple trending can do for an executive team.

Operating Margin Percentage

So what is the most important ratio to measure how the management team is performing? If you take the Operating Income divided by Sales, it will give you the Operating Margin %. On the left, you will see RSH, MSO and SHLD all trending down from the current year to the last 5 years. Not only are they trending downward, but also have gone into the RED zone, or negative value. Red Zone indicates that the business operation does not have a positive outcome or is below zero. In other words, the management performed unfavorably. From here, you can guess that RSH, MSO and SHLD correlate to negative net income or net loss in the business.

Chart 1, on the right Chart 1, you can see DIS, APPL and GOOG pretty steadily maintain an upward trend with operating margins ranging from 16% to 35%. You have probably already concluded that DIS, APPL and GOOG all have positive and substantial net income. And you would be right!

Free Cash Flow / Sales Percentage

“A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base [4].”

It is critical to understand that “profits in business are like food, and cash is like oxygen [5].” “Humans can go without food for up to three days and most likely survive with little problem. But humans can’t go ten minutes without oxygen without certain death [5].” (I’ve mentioned this before in a previous article.) Operating Margin percentages mentioned above could be considered “food” and Free Cash Flow could be considered “oxygen.”

On the left side of Chart 2 above, you can see RSH, MSO and SHLD have been trending downward the past 5 years and are in the negative zone. I would guess that RSH, MSO and SHLD are in trouble, relying heavily on debt as life support. When a business is in trouble, it becomes very hard to make wise decisions, because the goal becomes just to catch a breath. Innovation is not a priority.

On the right side of the Chart 2, you can see AMZN, DIS, AAPL and GOOG fairly consistently maintain steady trending. Even though AMZN has been in the press lately about performance, and you can see AMZN may be trending downward, it still stays in the positive. This simply indicates AMZN may be struggling more than DIS, AAPL or GOOG.

Market Cap

“If a company has 35 million shares outstanding, each with a market value of $100, the company’s market capitalization is $3.5 billion (35,000,000 x $100 per share) [6].” Market Cap fluctuates based on investor sentiment or, in other words, how they feel about the company yields and returns.

Market Cap also represents the market value of the company. Trending upward means the company is worth more over time, while trending downward means a company has less worth value.

On the left side of the chart below, RSH, MSO, and SHLD are all trending downward in the past 5 years, In contrast, on the right side of the chart, you’ll see AMZN, DIS, AAPL and GOOG are trending upward.

Conclusion

As an executive, you and your team can use trending direction for critical business decisions. Many of the public, private, large or small businesses use a rolling 18-month look to identity any trending patterns. The rolling period can be weekly for sales number as well, depending on how closely you monitor performance. If you only look at trending patterns on an annual basis, you might miss spotting important patterns.

You can use these same patterns to forecast business outlook. The majority of any Fundamental Financial Analysis ratios are lagging indicators. The executive team must identify leading indicators to seek trending that still has opportunity to impact lagging indicators.

When you are being measured by lagging indicators such as Operating Margin Percentage, it is up to you and your team to act, adjust or change the course so the business can stay on track to meet all stakeholders’ expectations.

If you would like an expert eye to help identify trends in your industry, schedule an appointment today!

Reference:

1 Berr, J. (2014, December 30). 6 brands that may not make it through 2015. Retrieved from http://finance.yahoo.com/news/6-brands-may-not-2015-103000752.html

2 Berr, J. (2013, December 27). Five Companies That May Not Survive Past 2014. Retrieved from http://www.thefiscaltimes.com/Articles/2013/12/27/Five-Companies-May-Not-Survive-Past-2014

3 Data Source from Morningstar, Inc. Retrieved date December 30, 2014

4 Free Cash Flow (FCF) Definition | Investopedia. (2003, November 23). Retrieved from http://www.investopedia.com/terms/f/freecashflow.asp

5 Chien, C. (2014, September 19). Business Succession Takes “Considerable Planning.” Retrieved from http://chialichien.com/cal/blog/565-business-succession-takes-considerable-planning.html

6 Market Capitalization Definition | Investopedia. (2003, November 23). Retrieved from http://www.investopedia.com/terms/m/marketcapitalization.asp