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It is wise to research and identify the real profit that a company generating from the sales of its products after reducing the involved manufacturing costs. This will help an investor to understand the real profit of a company as well as the possible
cash generating capacity. It not only help an investor to identify the ability of a company to survive for long term but also, helps to invest on the best company among the group.As we thinking, it is fairly difficult task to understand the original profit that generating by a company from the sales after reducing all the manufacturing costs involved. But as a true investor, one should find time and resources to identify all these facts prior to make any investment decision. This is the reason legend investors keep informing retail investors to not invest to any company directly once if you don’t have time to do proper research and study.I will make you understand what exactly it mean by a simple example.Two companies, Company A and Company B, manufacturing and marketing similar widget with a price tag of $10 each. Company A have a production cost of $6 per widget and company B have $9 at the same time. Thus they are presently getting $4 and $1 profit from each widget. Due to strong economy and customer interest on these widgets, both companies decided to increase the price from present $10 to $12 per widget. With this scenario, Company A starts receiving a profit of $6 per widget, that is a flat 50% increase in the profit. In other side, Company B having a profit of $3 per widget, compare with their previous $1 profit per widget, they are showing huge 300% increase.In such situation arises, to which company an investor will invest? Here is the mistake most of the investors committing. By seeing the 300% flat profit on the paper or from the analysts reports, most of the investors start investing on Company B that the Company A who got a 50% profit.But the hidden fact is, Company B getting only $3 per sale compare with $6 that Company A receiving at the same time. Analysts probably compare the previous the present profit with the previous profit both companies registered but the cash they receiving to their balance has huge difference here.
Sounds good and interesting. Now imagine, some one invested on Company A and other person invested on Company B by seeing their huge profit in the paper or tip from any analysts.
Suppose the situation changing now. Due to economic recession or losing interest from customers, each of these companies decided or forced to slash its product price to $8 per widget. What will be the situation now? Company A still able to generate a profit of $2 on each widget because its production cost per widget is $6 as I mentioned earlier. Company B, who have made a 300% profit, has a production cost of $9 per widget, immediately fall to sharp lose of $1 per widget and thus the business also starts run under lose.If such, what will be the situation of investors who have invested on both companies? Investor who have invested on Company A by carefully research all required facts and invested intelligently still continue receiving profits and investors who have invested on Company B by not identify the fact behind its previous 300% profit figure start suffering from huge lose of money.
From the above example, as an intelligent investor, one should do proper research and understand each and every aspects the business, cash generating capacity of a company to survive any situations. Compare with Company B, Company A might have huge cash surplus from the handsome profits receiving on their products with less manufacturing costs. They can easily manage any situations due to the cash reserves they have compare with Company B.
Cost effectiveness is a required measure to analyze a company. Never invest on any company by seeing the huge numbers in the paper or the result. Instead, do proper research to identify the fact that directly affect to your investment in the future.This is the technique a value investor should use to identify the value of a company when investing on it. Of course it require time. But, the result will be a fail proof one.Welcome any feedback on this article that you have. 