I've previously seen this book (The Art of Profitability) but ignored it. There are a lot of good book recommendations within the Art of Profitability too. Also thank you to Mr. S for introducing me to contract law and different terms and giving me so much to learn. I don't know how to repay you guys.
The Art of Profitability shows different business models and ways to make a profit. The author gives several examples and profitability/business models.
Notes:
To succeed in business, you need a genuine interest in profitability. You have to meticulous with the numbers and think about the numbers in simple arithmetic and what the numbers imply and if your business model works.
The book shows how big companies stay stagnant despite knowing what the correct business model to pursue. Once the customer has different preferences or if the customer changes, your business has to change to cater to it. They are too stuck in their old ways and won't change even if they go bankrupt.
The author recommends a book on simple math and how important simple calculations from accurate sources will give you all the answers you need. Some basic calculations can give you a feel for the business.
Most people don't ask shrewd and penetrating questions about what is pertinent to a business' future success or failure. Is the product is correct and commercially viable? Does the business plan work? Is the marketing campaign is good or a waste of money?
The author claims that with the right mental models and calculations you can expose an impressive but fatally-flawed business plan.
Being able to quantify the business reality of a situation with basic algebra is one of the most crucial skills we can develop. It's a good opportunity and lie detector.
The book gives an example of using quick arithmetic to estimate the number of trucks required to dig away Mt. Everest. There are many ways to do it, such as assuming the height to be a mile instead of five, rounding off numbers for easier calculations, assuming a mountain is a cone, etc.
It also reminds me of Buffett's innate ability to memorize crucial numbers and use simple arithmetic to calculate how fast something compounds.
From a mental math website and Robert Hagstrom's book:
He (Buffett) was posed this question and answered it very quickly in his head
"If the price of a painting goes from $250 to $50 million in
one hundred years, what's the annual rate of return?"
His answer was approx 13%, the interviewer was stunned how he knew it so quickly. The interviewer wanted to know how he did it. He said this
"Buffett pointed out that any compound interest table would reveal the answer. Another way to approach the problem, said Buffett, was
"to go by the number of times it doubles ( $250 doubles about 17.6 times to get to $50 million, a double every 5.7 years, or about 13 percent a year )." Simple, he seemed to say.
Far more likely is the use of the Rule of 72, which is known by all finance types.
The Rule of 72 says that the doubling time at x% is 72/x. In other words at an interest rate of 10% compounded, a sum will double in 7 years.
Now $250 to $50M is a factor of 200,000. The base-2 log of 200,000 is about 17.6.
Now if it doubled 17.6 times in 100 years, it doubled every 5 and a half years or so; 72/5.5 = 13+.
The author stresses what Li Lu stressed in a Columbia lecture. Train you brain to do mental arithmetic and don't rely on calculators. See the big picture.
The author also stressed that we should learn things similar to the mathematician Hildebrand, in compartmentalized forms each month. We learn things in an S curve and it takes time.
He claims that there are 4 levels to learning : awareness, awkwardness, application, assimilation.
He also also tells us to always ask "why?" five times. By the fifth time you'll get close to the real answer.
The author suggests scuttlebutt similar to Phil Fischer's approach. To study successful businesses you have to visit their offices, stores, customers, suppliers - try their products, test their services, spend time at their stores or websites, etc. More importantly, you've got to talk with their customers, understand what makes them tick and which products they like. You can learn more in an hour with a customer then 50 research reports.
Questions & Implications for your organization
Which of these profit models are at work in my business? Can I identify others?
How does my competitor generate a profit? What is their business model?
What can I do in the next few months to intensify my organization's focus on profitability or cashflow?
Which profit models would enable us to maximize profit this year?
Is my organization aligned to capitalize on the profit models in my business?
Customer Solution Profit
Know and study your customers well enough to create a tailor made solution.
Example:
A great story in the book was about how the financial data firm FactSet killed earlier competition despite having a smaller team. They sent a small team to each customer to tailor make the software to meet each firm's need at an initial loss. The idea from this is to lose money for a short amount of time but make money over the long haul.
This makes he product sticky, because of the customization. FactSet had a genuine knowledge of each customer's needs. After the software was installed and the relationship built, only one or two people were required the maintain the service.
Pyramid profit
The author gives an example of Mattel preventing the competition from attacking Barbie by selling both cheaper dolls and high end versions to prevent others from coming in at different price points. Different customers accept different prices. Having different tiers allow you to cross-sell or act as a sacrificial "firewall" to block other brands from capturing the market. You can't build a pyramid without truly understanding customer's current and potential needs. The cheap versions are barely profitable, but it builds a connection with some daughters and they move on to buy houses and accessories for Barbie and may once in a while buy the premium, expensive versions.
The author goes to explain that when you go to a gas station, premium gas rarely sells well, because the demand for gas usually is just for the lowest cost. He also explains why American express has built a mediocre pyramid for the same reasons.
Multi-Component Profit
Author's example, Coke:
Different parts of a business can have extremely different profitability.
The customer behaves very differently on separate purchase occasions and will pay a different price.
different pricing for the same product such as coke in:
1. grocery stores(2L bottle for $19 or 2 cents/oz) ,
2. restaurants (10-12 cents /oz),
3. vending machines(about 75cents for a 12oz can or 6-7cents/oz)
It is the same product, seen in several businesses.
The author didn't mention this example, but Gillette and Playstation is an example of
offer a range of services that includes higher margin specialty items and loss leading, high demand services. Playstation sells the initial hardware at a lost and charges developers and customers later. Gillette makes a profit through the blades you buy. Telmax, Carlos Slim's telecommunications company sold handheld phones at a lost at convenience stores, only to make a profit at monthly renewal plans.
For hotels, he mentions that they cater to single room for one night short term customers, one-day meetings for dozens of people, and conventions for hundreds or thousands of people.
He then gives an example of a consultant who saw bookstores such as Barnes and Noble as a base for building several new high-profit components: corporate business, book-group business, personal service business and encouraged them to market outbound selling activities, which finally gave a non-profitable bookstore a million dollars in profit. He recommended services to local book libraries and associations and promoting sales to individuals who bought over 500 dollars a year, but the owners never tapped into this segment by deliberately marketing these services to them.
Switchboard Profits
Another great example was when distributors or middle men obtain power in a supply chain and when they don't. The author states that when the distributor gets big enough with enough clients and merges multiple services to act as a contractor/service provider, they can gain pricing power and a larger margin due to multiple groups joining the switchboard.
A great example the author used was Ovitz. They put most of the need of producing a movie in one basket by representing directors, actors, stuntman, technicians, etc, etc.
You really can't do it with a small niche, since once you have 15-20% of market, all deals flow to you and perceived probabilities rise.
Being a distributor or agent is only profitable if you are a consolidator and bring multiple partners into one deal and is hard to be replicated by your competitors once you have scale. Studios have to cater to you and you have more say. The author goes on to say that profitability per unit of effort and time is probably 7x to 10x greater than the traditional model.
The author continues with multiple profit models. I think it is too many and can be condensed into less than 10. I think creating too many models is a distraction.
Same with people who stress on the "correct" valuation or the gordon growth model, dividend model, merton options model, comparisons, DCF, etc.
It is like people who claim their religion is the best and want to convert others into it.
Earnings Multiples such as enterprise value to operating earnings, etc allow you to compare companies and are a proxy to discounted cash flow models. There's no one general model which will tell you this is "cheap", and you may have to factor other qualitative factors such as the risks of the industry, the durability of the competitive advantage, which would make you want to price your purchase price higher.
However, I will say this though, you need to know what variables are important for different industries and what makes certain industries tick. Such as combined ratio and reserve tables to tell if your insurance company had a profitable year; non-performing loans for banks. You need to know the limits of accounting and modeling and with every model, the ultimate goal is just to gain more insight into the figures of the business. It is impossible to predict to far into the future, and most earnings dwindle as you go further out.
By the way, on a different subject - let's hope Djokovic beats Federer in Wimbledon 2019. I agree Federer is the more well rounded one and the crowd will cheer for Federer, but let us root for the "under-dog".
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