Profit Or Principle Case Study

Do you remember this guy?

This is the sock puppet from pets.com.

Pets.com was a high flying company in the late 1990s, early 2000 period.

They had built an iconic brand with their sock puppet.

They had achieved worldwide visibility, by selling pet supplies online.

Their sock puppet was well known for his Super Bowl commercials, and

it even had a balloon in the Macy's Thanksgiving Day Parade.

And then the dot-com bubble crashed, and pets.com went out of business.

Now, why did that occur?

There's lots of different reasons, but

let me highlight one that I think is really central to the failure of pets.com.

At the end of the day, it's not that hard to sell pet supplies online and

in fact there were numerous competitors to pets.com.

This competition made it very hard to be profitable in this segment.

This story highlights what I like to call,

the Fundamental Principle Business Strategy.

Simply stated, if everyone can do it, it's difficult to create and

capture value from it.

Pets.com, suffered from the fact that lots of people were selling pet

products online.

To be more technical, let me provide the following alternative definition.

In a perfectly competitive market, no firm realizes economic profits,

or what are often termed economic rents.

So, let me discuss this in a little more detail.

First off, this concept of economic profits or rents.

The definition is an economic profit or rent are returns in

excess of what an investor expects to earn from investments of similar risk.

In other words, in excess of the opportunity costs of capital.

This is the idea that the economic return you need from investment must exceed

the alternative uses you might have of that money.

Consider the following two examples.

One company takes $100 million and turns that into a $1 million profit.

Another company takes $10 million and turns that into $1 million profit.

Clearly, the latter example is a more sound and attractive investment.

Both generated to be clear $1 million worth of profit, but

the first one took more money to generate it.

This, in essence, gets to this idea of the opportunity cost of capital.

How else could they have invested that $100 million?

Could they have invested it in another investment

that would have had a higher return than $1 million.

Let me illustrate this with some data here.

Here we have three companies, iconic companies.

This is data from 1998.

And it expresses both, their accounting profits,

what they report in the popular press and in their annual reports and

their actual economic profits, factoring in this opportunity cost of capital.

So first we have IBM.

IBM north of $6 billion in accounting profit, yet when we calculate

the opportunity cost of capital, mid-$2 billion or so created there.

Compare that to Microsoft there.

Over four billion dollars in accounting profit reported.

But nearly $4 billion in economic profit as well.

This is in part because of the nature of the software business.

There's huge fix costs in developing an operating system let's say.

However, once you have the operating system built,

the marginal cost is next to zero.

And as a result, as Bill Gates once famously said,

it's like printing money once you have a dominant operating system.

Compare that to General Motors.

General Motors in 1998 did produce a profit, accounting profit that is,

nearly $3 billion.

However, when we consider economic profit, it was nearly a $5 billion loss.

Why such a drastic difference there?

Well, in part, it was because hundreds of billions of dollars had been spent by

General Motors to generate that $3 billion worth of profit.

Again, the opportunity cost of that capital could

have been used in other ways that would have likely have been

far more profitable than what General Motors was doing with that money.

So, one might ask, how do we measure economic profit?

Well, a common way that strategy researchers use is what's called

Tobin's Q.

In its simplest form, Tobin's Q is, in essence,

the ratio of market value to book value.

Technically though, what we actually wanna look at is the asset replacement value.

So the firm's market valuation.

What the market thinks the company is worth

versus the replacement value of the assets on hand.

So one thinks about Facebook, for example.

Facebook has a very high market valuation, so the market thinks it's very highly.

But the replacement value for its assets is probably fairly low when

you think about the relatively small employment they have and

the number of assets they have on hand there.

That difference is what we're looking for here.

What This is does, in essence, is directly measure these economic rents we're

interested in, above the physical inputs that the company might possess.

The challenge with Tobin's Q is it's often difficult to actually calculate this

replacement value of assets here, and

requires a knowledge that you may not have at the organizational level.

An alternative is what's called discounted cash flow.

Discounted cash flows are ways of measuring the value of

the firm going forward.

It's a measure of the revenue minus the costs

minus other investment the company makes moving forward.

We discount those cash flows because the value of money is worth more today

than in the future.

And in essence this discount rate that we use reflects the actual return on equity,

in essence, this opportunity cost we're interested in.

So the discount rate would reflect both inflation.

But also the rate of return we expect to get above inflation for

similar investments of similar risk.

And at the end of the day, we calculate what's called a net present value.

And a positive NPV, or net present value, indicates rents over and

above the referent returns to all other inputs.

And this is somewhat the gold standard for measuring economic profit.

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