Too often, investors are attracted to high-performing (and often expensive) stocks in search of superior investment opportunities, only to discover that the performance of these types of securities is largely a function of short-term market movements and is not necessarily indicative of long-term value creation. What they need is a way to isolate the key value drivers within a company and hold them accountable for creating sustainable earnings power and growth.
The Definitive Comparison
To solve this problem, we have developed a method of comparing the financial performance of any two companies side-by-side, based on a common set of earnings metrics that are adjusted for the peculiarities of each company’s business, including the effect of stock options, corporate governance, and tax rates.
By isolating these three factors—which we will explain in more detail below—we can determine how much corporate performance is due to a mere change in the market price of shares and how much is due to company-specific factors such as innovation and growth of the business.
- Keep an eye on how much cash flow the business generates
- Focus on the profitability of the company as a whole
- Investors often get distracted by the price movements of a stock and fail to look at the underlying financial performance of the company, which can be influenced by a variety of factors, only a few of which are within the control of management
- TDC can help you make better investment decisions by giving you a complete picture of a company’s financial performance, from which you can draw important insights about its sustainability and growth potential
- The goal of any investor should be to find a financially intelligent way to participate in the growth of the global economy
What Is TDC?
The purpose of the Total Dollar Cost technique is to provide investors with a common metric by which they can compare the relative financial performance of any two companies, no matter what their industry or what country they’re based in. TDC isolates the following 3 factors that influence a company’s profitability from a dollar perspective:
- the cost of goods sold (which includes raw materials purchased for production)
- the cost of labor (which can be adjusted for the cost of living)
- dividends and interest on debt
- taxes (including corporate and income taxes)
- the effect of changes in currency exchange rates
- the market prices of your company’s traded securities
- the behavior of customers (as measured by customer activity, such as orders for your company’s products, value-added services, and so on)
- your company’s stock option costs
By removing these variables (or at least controlling them), we can determine how much of a company’s current performance is due to economic factors beyond the control of management and how much is instead due to superior execution and a favorable business environment.
In addition, TDC allows investors to compare companies on an even playing field, as all factors, including the market price of the company’s stock, are adjusted for differences in geographical location and for the peculiarities of each company’s business, such as the cost of doing business in a certain country.
While these three factors—cost of goods, cost of labor, and taxes—are important, investors often get distracted by the market price of a stock and fail to look at the underlying financial performance of the company. Just because today’s price for a stock is $x per share doesn’t mean that the company is actually making $x per share in profits. In fact, it could be making a loss. Take a pharmaceutical company, for example. Its stock price might be trading near $100 per share, but what happens if the cost of medicines increases substantially because the company is unable to negotiate lower prices with healthcare providers? In this case, the company would actually face a significant earnings decline despite its share price rising on the news.
As a result, investors might avoid stocks that are trading near $100 per share, even though these companies could very well have lower operating costs, as it’s often the case with biotech and healthcare-related stocks. If the market price of a company’s stock goes up for no apparent reason, it could be a warning sign that something is awry and that the share price might decline in the future. On the flip side, if equity securities in a company are selling for less than their intrinsic value, that is, if investors believe that the company’s earnings will decline in the foreseeable future, the share price could be seen as cheap and a potentially good buy.
In short, keep an eye on how much cash flow the business generates, you’ll know whether to buy or sell based on the results.
How Does TDC Work?
The Total Dollar Cost technique is based on the principle that, within a company, the costs of selling a product or providing a service—that is, the direct expenses of producing that product or providing that service—are typically a smaller share of the overall profit than the expenses associated with buying the raw materials, hiring workers, and paying the bills, as these all have to happen in advance, regardless of whether or not you end up selling the product or service. Therefore, these kinds of costs are removed from the income statement and placed in a “Cost of Sales” line item, which is then totaled up with the rest of the company’s income to create a “Total Income” number.
In essence, TDC is a way for investors to take a closer look at a company’s income statement and determine whether or not the income they’re generating is actually worth what they’re paying for it. Is the cost of labor decreasing or increasing the amount of money the business is making? Is the market price of the company’s stock going up or down for no apparent reason? In these kinds of situations, the stock might not be a good investment, as there could be negative trends happening that management isn’t acknowledging or acting to correct. If you have the time, it’s always better to wait for the trends to resolve themselves rather than rush in to make an investment, as you might create a situation where you’re not able to buy shares at a favorable price.
The Different Stocks, One Chart
The Total Dollar Cost technique was developed to analyze the relative financial performance of any two companies, no matter what their industry or where they’re based. As a result, we needed to develop a way to show the results on a single chart, as the expense ratios or other comparable financial ratios that are used for intra-company comparisons can vary dramatically from company to company.
To solve this issue, we decided to create a simple but comprehensive way of showing the results, which we called the Definitive Comparison chart. What we did was we converted each company’s income statement into a line chart, where each bar represents a twelve-month period. We then plotted the Total Income—that is, the sum of the income from sales and the income from other sources, including interest and dividends—for each company on the y-axis and compared it to their Cost of Sales on the x-axis. In this way, we were able to create a clear and concise picture of how much money the company was generating relative to the amount of money it was spending.
The reason we chose to compare Total Income to Cost of Sales is because this is how a business’ profitability is typically shown in an income statement. It is also, however, the best way to compare the financial performance of two companies, as Cost of Sales is a direct reflection of the company’s expenses, while Total Income includes all of the company’s sources of revenue and can, therefore, take into account the effect of fluctuations in the market price of its stock and the cost of doing business in a certain country, among other things.
Why Care About TDC?
TDC is, at its heart, an effort to give investors a simple and intuitive way of looking at a company’s financial performance. We hope that this technique will help investors make better investment decisions by providing them with the information they need to determine whether or not a company is a wise investment based on a sound financial analysis. Of course, none of this information is actually available to the general public—at least not yet.
The reason why we’re not yet providing this information to the general public is because we’re still working hard to ensure that this benchmark is as comprehensive and accurate as possible. Even after we make this information available to the investing public, we will continue to develop new methods and tools to help investors analyze and compare the financial performance of any company to any other company. After all, the best tool for one job is usually the best tool for another job as well.