As my wife will tell you, I'm a vegetarian with a pork problem. More specifically, I have a soft spot for smoked ham, bacon, and of course, hot dogs. My "happy place" is officially Johnny's Dog House on Route 202, where (I'm embarrassed to say) I have a frequent flier membership.
So, when it came time to talk about various financial ratios with StratFI's summer intern, my mind just happened to wander upon a reoccurring private fantasy of running a hot dog stand.
In summary, there are three ways to make money selling hot dogs. You can go gourmet, like Johnny's, and charge $5-$6 per hot dog, earning a good profit margin. Or, you could sell cheaply, and make money by selling in high volume, like Oscar Meyer. Finally, you could ditch the hot dog stand, take out a loan, and buy a fancy restaurant. That means that you could support a bigger customer base - with some help from other people's money.
These strategies can be summarized by three different financial ratios:
Profit Margin = (Net Income / Sales)
Asset Turnover = (Sales / Total Assets)
Operating Leverage = (Total Assets / Common Equity)
Roll it all up and stick it in a bun. You now have a tasty measurement of profitability known as the Dupont Return on Equity. ROE = Profit Margin * Asset Turnover * Operating Leverage. (Yes, Dupont did far more than invent nylon!)
Usually, I like to see ROE's in the mid-teens, if possible, when I look for investments. Over time, high ROE's should translate into higher growth for a company's stock. Changes in any of these components will have an influence on profitability.
These three strategies can also describe how different players make money in the financial markets. You could be selective, making a smaller number of trades and holding for bigger gains (my preference). This is gourmet-style investing. High frequency traders try to sell as many hot dogs as they can during any given second. Finally, many day traders and hedge funds borrow big amounts of money to magnify their profits - buying the restaurant and mortgaging it to the limit.
These are all entirely different approaches, but they all have the potential to generate profits.
You see, my hot dog problem explains everything. And we haven't even talked about the mustard yet...
-Jim Lee, CFA, CMT, CFP®