Warren Buffett once said, "beware of geeks bearing formulas." Despite the oracle's sage advice, there is one formula every investor should know. It's very simple. Even Warren would agree: it's so easy a caveman could do it. Here it is:
Profit = Revenue - Costs
Profit can be broken down into revenues and costs. A company can either raise profit by increasing revenues or by decreasing costs.
The easiest way to increase revenue is to increase prices. If sales remain constant, profit will rise.
Earlier this year, Disney (NYSE:DIS) announced it would be raising its single-day admission prices to its theme park by 5.7%. This brings the price of an adult ticket to $92. The company is no stranger to admission hikes; this is Disney's fifth price increase since 2009. Despite the higher prices, park attendance remains consistent, with nearly all of Disney's parks recording increases.
In May, Disney reported a 5% rise in revenue. The formula never fails, and looking down the income statement, we can see that the company increased profits by 1%.
Even with the stock market booming, diligent investors recognize that the economy is far from healed. Unemployment hovers around 7.6% and consumer spending remains well below pre-recession levels. With consumers cautious to spend, how can a company like Disney raise its prices? To find the answer, look to fellow S&P 500 member Apple (NASDAQ:AAPL).
No one on Wall Street knows revenue quite like Apple. The company has not reported a year-over-year revenue loss in over 10 years and has maintained an average gross margin of 40.3% over the past five years. Even with consumer spending down, Apple manages to sell its expensive phones, tablets and computers with relative ease. How does it do it? By offering a unique selling point.
Apple's products are stylish and exceptional. No other company offers this tandem. As a result, 91% of existing customers will return year after year to purchase one of Apple's expensive upgrades. Just as Apple offers original products that can't be purchased elsewhere, Disney provides customers with a unique experience that is not easily replicated. Pricing power allows these companies to maximize revenue and create a long-term competitive advantage.
While increased revenue adds to profits, larger costs eat away at them. Costs are rising in nearly every industry, and most companies that deal with consumer goods can't afford to hike prices like Apple or Disney. There is simply too much competition. While brand names carry weight among consumer goods, the fact is that when customers are pushing pennies, the lowest price usually wins.
The pioneer of low-priced food, McDonald's (MCD), finds itself in a precarious position. Commodity costs such as wheat and beef are rising quickly and in order to keep margins level, McDonald's is passing the difference on to customers. The company raised prices by 1% across the board in early March, and plans on introducing similar increases within the next few months.
McDonald's saving grace is its dollar menu. With over 13,000 locations in the United States, the company can take advantage of its economies of scale. McDonald's can sell a few select items for $1, and at razor-thin margins still remain profitable.
Fortunately, consumer spending might finally be catching up with increased costs. In July, domestic McDonald's reported same store sales increasing by 1.6%. McDonald's remains profitable thanks to strong revenues that continue to offset its rising costs.
The cost of competition
Commercial airliner Southwest Airlines (NYSE:LUV) finds itself in even greater danger. The airline's largest operating expense, jet fuel, increased by 40% in the past year. The worst news is that Southwest can't afford to raise its prices. Southwest's unique selling point is its rock bottom prices. If an industry peer is able to undercut its prices, Southwest can say goodbye to its economical reputation.
In order to remain profitable, CEO Gary Kelly announced that Southwest increased its domestic round-trip fares by about $10. Even with this slight increase, Southwest still offers some of the cheapest flights in the U.S and finds that passenger traffic increased 4.2% since last year. Unfortunately, these passengers aren't translating into profits. Southwest's unit revenue (passenger revenue per available seat mile) dropped 6% in the past 2 months. Unless Southwest is able to shed some of its costs, its profitability may begin to wane.
How you can profit
When economies slow, companies with pricing power always win. Costs will rise over time, but companies that can raise prices without fear of competition are historical victors. The formula is simple, but finding companies that know the formula takes work.
A high gross margin is a great place to start. In fact, take a look at the gross margin from the past ten years. If it is consistently high in comparison to the rest of the industry, you may have a winner on your hands. Next, look at operating margin. If it's over 20%, chances are you have a company with a competitive advantage that knows how to find profit.
Learn the formula, find a company that knows it, and your portfolio will profit as well.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.