Profit magnitude AND duration

It's not enough to focus on a company's profitability--especially if it's huge; you must also understand the durability of that profitability.

A single payout of $1 million is not worth as much as a lifetime payout of $150,000 a year forever (unless you can get better than 15% returns forever). The same is true with buying businesses (whether in the form of a whole private business, or shares of stock).

This may seem elementary, but some investors lose this focus when they dwell on short term high or low profits. A couple of examples may help concretize this point.  

Exxon Mobile is a hugely profitable company. But, there are non-trivial questions about whether it can replace its current productive capacity over the next 10 years.  

Or, consider Apple. It's hugely profitable right now, but can that profitability be sustained and grown in the face of many smart and well-resourced competitors (that are spending 2x to 4x as much on research and development)? The answer to that question is vitally important for Apple's valuation.

Or, what about Sprint (the telecom company)? It's clearly not making money now, but the price paid for the company should reflect profits 5 and 10 years from now as well as this year. Does Sprint's valuation reflect its current profitability or its profitability over time?

Think about Research in Motion, the maker of Blackberry mobile phones. It had rapidly growing sales and profits within the last year, but both have started rolling over. Will that trend accelerate, continue, or reverse?  The value of the business hinges on the outcome.

I don't mean to imply that answers to these questions are easy--they aren't. In fact, I'll be the first admit I don't have the answers to any of those four questions. But, they must be thought about in order to achieve good investment results.  

I should know, I've fumbled that ball several times in the past (business analysis is extremely complex, and no one is omniscient). I bought Reebok and Novell in 1996 after years of outstanding profitability. Over the following 10 years, though, both saw profitability and their stock prices tank--a great lesson that durability of profits is more important than recent magnitude.

Think about stalwart companies like McDonalds, or Coca-Cola, or Proctor & Gamble. They have extremely high profitability and almost zero chance of seeing that profitability vaporize like we could see happen with Exxon, Apple, Sprint or Research in Motion. That's why their stock prices are almost never as low relative to fundamentals. Investors as a whole get this concept, even if they forget it at times (1999 and 2000 for technology, 2005 and 2006 for housing).  

As I said last week: it's not about market share, it's about profitability. Now, I'd like to add that it's not just about profitability, but also durability. Your investing future depends on both.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.