# Understanding Business Statistics

1) Gross Margin

__What does it tell you?__

Gross margin is the amount of each sale that is not taken up by direct product or service costs.

__How do you calculate it?__

(Revenue - Cost of Goods or Services) / Revenue

__What's good or bad?__

Gross margin is highly dependent on the business, but in general, the higher the better. An excellent value is over 50%. Many companies do not report gross costs separately.

__Simple example__

A supermarket buys a box of macaroni for 0.70 from Kraft. It then sells it to you for 0.80. It gets to keep 0.10 for itself (gross profit). The gross margin is therefore 13% (0.10 / 0.80).

2) Operating Margin

__What does it tell you?__

Operating margin is the amount of each sale that is not taken up by costs associated with running the business.

__How do you calculate it?__

(Revenue - All Operating Costs) / Revenue

__What's good or bad?__

As with any margin value, it depends on the business. Really great business models can have operating margins north of 30%.

__Simple example__

After making it's 0.10 gross profit on the macaroni, the supermarket has to subtract 0.02 to go towards paying it's employees, advertising on television, paying for trucks to deliver it's food, etc. The leftover profit is 0.08. Operating margin is therefore 10% (0.08 / 0.80).

3) Net Margin

__What does it tell you?__

Net margin is the amount of each sale left to the business after all costs, including tax and interest on debt, are accounted for.

__How do you calculate it?__

(Revenue + Non-Operating Revenue - Total Costs) / Revenue

__What's good or bad?__

By now you know that all margin figures are relative to competitors! In general, a net margin over 15 or 20% is the sign of an excellent business.

__Simple example__

The supermarket has some cash in the bank earning interest, but also some debt on which interest must be paid. Broken down to the single box of macaroni, it earns 0.001 of interest, but owes 0.003 of debt (a net interest cost of 0.002). Leftover profit is 0.078. Net margin is therefore 9.8% (0.078 / 0.80).

4) Return on Assets

__What does it tell you?__

For all property, machinery, trademarks, cash, etc. - all assets owned by the company - how much profit is earned from them?

__How do you calculate it?__

Net Profit / Total Assets

__What's good or bad?__

In The Little Book That Beats The Market, Joel Greenblatt lays out a hard percentage to look for - 25%. In reality, this is much higher than many stocks that appear on the screen. A good benchmark to look for is 15%, but the higher, the better.

__Simple example__

A lemonade stand holds $400 in assets - $200 for the mini-fridge, $100 in cash at the bank, $50 for the stand and signs, and $50 for the lemonade, pitchers, cups, and ice. Over a year, the stand earns $75 in profits. Return on assets is (75 / 400), for a good 19% return on assets.

5) Return on Equity

__What does it tell you?__

How much profit is earned from the net worth of the company?

__How do you calculate it?__

Net Profit / Total Equity

__What's good or bad?__

MagicDiligence feels that return on equity is a poor statistic. It can often be very high for companies in poor financial shape, as equity is very low due to high levels of debt. For companies with low debt, a good figure to look for is 25% or higher.

__Simple example__

The lemonade stand holds $400 in assets, but the mini-fridge was bought on a credit card, therefore the stand owes $200 of debt. Therefore, net worth is (400 - 200), or $200. Therefore, return on equity is (75 / 200), a 38% return on equity.

6) Return on Invested Capital (ROIC)

__What does it tell you?__

How much profit is earned from assets that are specifically deployed to earn money?

__How do you calculate it?__

This one is trickier. You first must calculate the net assets deployed to earn money. In general, this is:

Invested Capital = (Total Assets - Cash - Investments) - Current Liabilities + Short-term Debt

Then you use operating profit (EBIT - this is what we used to calculate Operating Margin in step 2), and subtract out the tax rate:

ROIC = (EBIT * (1 - tax rate)) / Invested Capital

__What's good or bad?__

Return on invested capital is useful because it's meaningful regardless of the business. A good ROIC is over 25%. An excellent ROIC is 30% or more.

__Simple example__

Our lemonade stand has $400 in assets, but the $100 in the bank is not being deployed to make money. Therefore our invested capital is $300. For the sake of simplicity, we'll say the stand does not pay taxes. Therefore, ROIC = (75 * (1)) / 300), or 25%.

7) Pre-Tax Return on Tangible Invested Capital (ROTC)

__What does it tell you?__

Finally, we get to one of the two golden statistics of the Magic Formula. Return on Tangible Capital is the same as ROIC, except we don't include intangible assets (like trademarks, overpayment for acquisition - goodwill, etc.) that are difficult to value. Also, we do not subtract out a tax rate, as they are variable between businesses.

__How do you calculate it?__

Take Invested Capital from item 6 and subtract out goodwill and intangible items from the balance sheet. Then:

ROTC = EBIT / Tangible Invested Capital

__What's good or bad?__

ROTC is a great statistic because it provides a meaningful comparison of businesses regardless of sector or tax rate or debt structure. It's also impossible to calculate for many Magic Formula stocks, as the Tangible Invested Capital figure is negative! Negative values and values over 40% are very positive, especially if the company holds a lot of cash.

__Simple example__

Think of a company like Microsoft. Software requires no warehouses to store inventory or factories to build products. Hard assets are minimal - the company relies on the ideas and skills of it's programmers and trademarks. This is a good business to be in, as there are no factories to upkeep or inventory to sell off to make room. These are the kinds of companies the Magic Formula looks to find, and MagicDiligence looks to review.

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