In early September, Nike set the internet and news media on fire when it employed Colin Kaepernick – former 49ers quarterback turned national political protester – to be the face of the 30^th anniversary celebration of its Just Do It campaign. While for some the campaign was brave and well-received, some opponents of this movement responded with a fire of their own: burning their Nike products in protest. Others were more moderate in their negative reactions, throwing away their Nike products or simply pledging to never buy products from Nike again.

But instead of digging into the divisive social and political nature of this campaign, which nobody reading this needs or wants to hear about again, let’s focus on something entirely different: the economic impact of a company diving into a hot social topic. Is it good business to take a bold stance on a divisive issue, or is a company best served by focusing on maintaining their business and that alone? Should a company never align itself with a cause outside of its core business or… just do it?

First things first, does a boycott adversely affect a company’s earnings?

In the case of Nike, it actually appears to have been a boon, with sales increasing by 31% the weekend immediately following the campaign’s launch compared to a 17% rise over the same period in 2017. Although Nike is a public company and therefore probably has more accessible data, a similar trend was seen with Chick-fil-A in 2012 following President Dan Cathy’s comments regarding the “biblical definition of the family unit” which were criticized by opponents as anti-gay. These comments were met by a protest and calls for boycott, which was responded to by supporters with a counter-protest to intentionally eat at Chick-fil-A the day after the initial protest. Sales appeared to skyrocket, and neither of these contentious statements appear to have diminished the actual business operations in either case.

Odds are, every single person reading this found one (or both) of these protests to be ludicrous, which means I’ve successfully alienated my whole audience, but I hope you’ll read on.

There’s a pretty simple economic and mathematical explanation for this. Let’s start with Nike, and let’s ask ourselves two questions: how likely are you to buy a piece of athletic apparel in the next 7 days? And how likely are you to shop specifically for a Nike product?

If you were to poll everyone in America with these two questions in the run up to Labor Day weekend before the Just Do It campaign launched, you probably would have gotten a fairly low ratio on both. Perhaps the average person had a 10-20% likelihood of buying a hat or a pair of shoes on that particular weekend, with more able to be tempted by a particularly good sale. Furthermore, for everyone who is brand loyal to Nike or its subsidiaries, there’s probably another who is loyal to Under Armour, or Adidas, or Reebok, so the answer to the second question, in aggregate, is maybe 25%. If everyone in America had a 20% chance of buying shoes in a given weekend, and a 25% likelihood that they would be Nikes, that’s a 5% chance that any given person will buy Nike near-term. Remember that number.

Now, Nike launches an ad campaign featuring a controversial figure. Let’s just say that the country is perfectly divided 50/50 in strong support and strong opposition to this figure. 50% of people light their Nike shoes on fire, throw them away, or otherwise swear off Nike forever. However, among supporters, this campaign significantly increases their likelihood of buying specifically Nike and specifically now. If, in aggregate, supporters doubled their likelihood of buying from Nike and further doubled their likelihood of buying something at all, then Nike is looking at a 50% rise in their sales (7.5% total likelihood after the campaign vs. 5% before):

Even though this is incredibly rough statistics, it illustrates the point. To put it in words, affirmative activism appears, at least when it comes to consumer products, to carry more weight than negative activism, i.e. boycotts. It’s not that boycotts are categorically worthless, it’s just that if there is a reasonably equivalent counter-movement, those in the affirmative camp punch harder economically than those in the negative. Someone out there may never buy another Nike product as a result of this campaign, but then, they were 95% unlikely to buy a Nike product in the near future anyway, whereas a supporter of the campaign probably marched into a store that very week with the specific intent of buying something with a swoosh on it. A similar pattern holds for the Chick-fil-A example. There are a dozen other fast food restaurants someone could go to on any given day, with the likelihood they’ll even have fast food at all substantially below 100%, but an avid supporter in the midst of a tumultuous social debate cranks their individual rate up to 100% overnight, becoming worth far more than they were worth on the sideline. In fact, the less likely it is that someone would specifically visit Chick-fil-A before the controversy, the more weight a counter-protester carries. To put it in even more simple terms (and use the most ham-fisted chicken pun ever), when it comes to the economics of companies engaging in divisive social issues, it seems a bird in the hand is definitely worth two in the bush.

This is of course discounting a whole lot of other factors. For one, Nike and any other company of their size almost certainly has mountains of demographic data that let them cheat the numbers further in their favor. If they know going into an ad campaign that 75% of their active customers approve of the message, they may not care if the majority of the whole world disagrees with them, because the whole world isn’t their target audience. If Chick-fil-A had instead made comments about veganism, the protest vs. counter-protest cost/benefit may have been even more pronounced, because an individual with a vegan diet is significantly less likely to be a recurring customer at a place with the word “chicken” in the name. Consider also the adage that “no press is bad press.” I’m currently a quarter of the way through the amazing behavioral economics tome Thinking Fast and Slow, so the power of mental nudging and association is fresh on my mind. Advertisements exist to create awareness, and it just might be a marketer’s dream to have one of their campaigns explode in the media, even if it’s in a contentious way.

I realize that all of this is fairly Spartan, perhaps even Machiavellian. That’s probably intentional, as I really wanted to sanitize this post as much as possible from the emotion of it all. Still, my goal has never been to ascribe those hardline tendencies to businesses. Business well-being is good for shareholders yes, but also other stakeholders like employees and the communities that the businesses live in and serve. Reputation is key in attracting and retaining talent as well as customers, and I think most people would laud companies who engage in corporate social responsibility. And there is certainly a place for boycotts when companies are found to be doing truly deplorable things. Some boycotts have even resulted in major social and cultural change… I’m sure at least one famous one comes to mind. However, for many of these high-flying but ultimately short-lived social issues, it appears that jumping into the fray can be safe and even beneficial if calculated carefully enough beforehand. Like it or not, it’s an economic quirk that lives squarely at the corner of free speech and free markets, both of which I hope are here to stay.

The year was 490 BC. The Achaemenid-Persian Empire, founded by Cyrus the Great some 40 years prior was the dominant force in the intersection of modern Europe, Asia, and Africa, and was still expanding under one of its greatest administrators, Darius I (he was also called Darius the Great… there were lots of great folks this century). Through Darius’ reign, the empire controlled the largest fraction of the world’s population of any empire in history… 44% or better of the entire world population at the time.

But despite his and his predecessors’ incredible, historical successes, Darius had a problem in his empire. A fiery, rebellious, independent people to his west. A bunch of separate, non-unified city-states that, though often quarrelsome with each other, were all extremely vested in protecting their land, their culture, and their freedom. That rowdy bunch of rebel cities came to be known as Greece. Darius had already suffered a major rebellion led by the Greeks, and was determined to crush them into submission. He mobilized his massive army and headed west.

Come 490 BC, his campaign was advancing. The Persian force sailed into a bay near the town of Marathon, 25 miles from Athens. But those darn clever Greeks used their knowledge of their home terrain and topology to their advantage. The Athenians and an assisting force of Plataeans bunkered down in the two exits from the plain that were the only easy paths to Athens and greater Greece. The terrain prevented the Persian cavalry from aiding in the battle, and the infantry fell into a well-laid trap. The Greeks feigned a weak center, choosing to reinforce their flanks, and when the Persian army pushed into the center of the field, the Greek flanks collapsed inward, crushing the best Persian fighters and sending the rest scrambling back to their boats.

Realizing that the home city of Athens was still under threat from the Persian fleet sailing on the city with few standing defenses, the Greeks left a token resistance at Marathon and hastily marched the bulk of the army the 25 miles back to Athens. There, they once again prevented Darius from establishing a beachhead, and send the Persians home packing.

Historical speculation is tenuous, but it wouldn’t be exaggerating much to say that without the victory at Marathon, those of us here in the 21^st century might look very different. The preservation of Greek culture against the invading Persians allowed the nascent “Western” culture that we enjoy today to continue to bloom.

To step even further onto the thin ice of historical speculation, imagine if the Persian forces could communicate as quickly as we do today. Let’s give Darius and his generals each a cell phone. What happens then?

Without question, the ability to communicate globally, instantly, as casually as we do today, if dropped in the middle of most human history, would be a complete game changer.

Now, rather than a cell phone, imagine you gave Darius and his men the material components of a cell phone.

A typical cell phone is in the realm of 150g of plastics, metals, ceramics, and some other trace stuff.

Darius probably would have looked at this handful of junk and discarded it. Maybe the metals would have been used to patch a piece of armor or fashion an arrowhead or spear tip.

2,500 years is a colossal amount of time when considering recorded human history. Still, the idea that any amount of time could turn a useless pile of materials into a tool that has changed the entire world is a humbling reflection of human progress. Even more humbling is the idea that something each of us carries around in our pocket all day and use primarily to watch cat videos and share partisan political memes is something history’s largest figures would have given vast wealth to gain access to.

But let’s get back to the point.

There are tons of theories on where economic growth comes from, but there are some central themes and concepts that stand out. The main ones we’re concerned with today are intensive and extensive growth.

To paint with a broad brush, intensive growth is “getting more out of the materials you already have,” where extensive growth is “getting more materials.” Darius’ flippant discarding of the materials of a cell phone is due to 2,500 years of intensive technological growth. Our present-day economy gets far more utility (usefulness) out of 150 grams of copper, iron, silicon, and petroleum, than the great Persian Emperors could have ever fathomed.

Over most human history, nations have warred over territory in an attempt to obtain extensive growth. When your people, your empire, are the sole focus of your leadership, taking someone else’s stuff is an easy way to grow. Subjugating your neighbors has historically meant more land, more resources, more labor at your disposal.

While we still squabble over international boundaries and territorial rights, humanity has just begun to enter an interesting stage of our development. We have, more or less, explored what our planet has to offer us. It sounds like science fiction, but early investors are beginning to look to other celestial bodies for resources. Serious people are talking about the possibility of mining asteroids and our neighbor planet Mars. It’s no doubt a field in its infancy, but the prospect is compelling – the materials contained within asteroids have been estimated in the tens of trillions, which, against the Gross World Product of around $75T, would constitute an immediate growth of the global economy by as much as 20%. If space mining is too far out to conceptualize, consider the amount of energy the sun throws at earth each day that could be captured to add a massive, constant resource to the otherwise closed system of earth.

And yes, all that is exciting and promising, at varying degrees. But most of us in the present world will probably never be a driving factor in achieving this kind of extensive growth. We happened to be born between the imperial and colonial eras and the economizing of space. Most of our lives and careers will be relegated to the far less sexy realm of small, incremental, iterative, intensive growth.

Being fully vulnerable with you, there was a stretch of years where I questioned whether working as a stress engineer in aerospace was a truly noble purpose. I always told myself that I was making better planes than the past, making them safer, and that those planes connected families and friends together, took people to new and exciting experiences, and greased the wheels of business and economic growth around the world. But my problem was, I never really connected with it. Running through loads iterations to take ounces of weight out of parts didn’t resonate with me, personally, as part of any meaningful progress. I think it’s a fairly common thing for people in their twenties to experience, and I’m no exception. Your formal education is complete, the excitement of getting into a “grown-up” job has started to fade, and you’re faced with that sense of normalcy, the realization that you’re not going to change the world so quickly, that for all your strengths and flaws, you’re not as special as you might have thought you were.

If you’re trying to think and feel your way through a similar existential crisis this little write-up probably isn’t going to be the lever that breaks you out of it. For me, it was reflection, continued learning, guidance from mentors, and consistent effort that finally broke me out of my negative feedback loop.

But maybe it will speak to someone. When I emerged on the other side, a more content, happy man, I realized that being a small part of something big is still doing big work. And sometimes, the work is so big you can’t comprehend it in a human lifetime. But that shouldn’t diminish your pride in what you do.

We all stand on the shoulders of giants. No one truly achieves greatness on their own. We may not be the first to set foot on a new planet, or pull the spoils of space back down to earth. But every time we prove a plane can be built with a little less metal, or fly a little further, or cost a little less, we’re contributing to a grand tradition of incremental growth that has propelled mankind to new eras, to the skies and beyond. Without the incremental change we fight for every day, quantum leaps wouldn’t be possible.

It’s a tradition we should be proud to play even a tiny part in.

In the early 1970s, Fred Smith founded Federal Express (FedEx) with a novel, new idea on shipping: an end-to-end model where one carrier was responsible for delivery from pick-up all the way to final destination. The business took off quickly until the fuel crisis slammed it, causing it to start hemorrhaging over a million dollars a month.

Smith lobbied his investors for more capital to stay in business, but was unsuccessful. He was waiting for a flight home after this critical rejection when an idea struck him. Knowing that they were well short of being able to make payroll and fuel the delivery planes with the cash they had, Smith devised a noble strategy: put it on black.

He grabbed a flight to Las Vegas and turned the company’s last $5,000 into $27,000 at the blackjack table. This allowed them to stay in business and operational for another week. Shortly after, and just in time, he was able to secure another $11M in capital from investors. The rest is history.

(For more on Fred Smith and the blackjack story, see here and here.)

There’s no denying that luck plays a role in business. We might call it by different names – macroeconomics, unknown unknowns, Black Swan events, whatever – but the gist is that there are things that we don’t control that we still must react to for our business to survive. We often hear about successes, but rarely failures. Survivorship bias is a particularly nasty flaw in human cognition and social study. Dead companies tell no tales.

Is there any real way to prepare for events we can’t control, and often don’t even know are coming? Famed business researcher Jim Collins’ team (of Good to Great and Built to Last fame) set out to answer this question in the book Great by Choice: Uncertainty, Chaos, and Luck – Why Some Thrive Despite Them All.

While the original work (and his others) are all worth the read in full, here are three behaviors and characteristics of companies that survived and even thrived in turbulent times when competitor companies in the same situation faltered and failed.

• Consistency: Successful companies adhered to what Collins calls the “20 Mile March.” In good times and in bad, they were determined to grow at a steady, sustainable pace. Often, this meant exercising discipline in slowing growth during favorable times so that it could be realized in down times. The great companies would often lag behind their competitors who courted massive growth in good times, but left no reserves for the bad. They would then catch and pass them for good with their steady, unflappable pace.
• Calibration: As Collins calls it, “firing bullets, then cannonballs.” With a limited amount of resources (people, capital, and time chief among them), companies that want to survive turbulence need to calibrate their efforts by starting small and gathering objective, tangible data before investing fully in a new and exciting concept. Going small at first helps refine your aim when the stakes are low and you have little organizational inertia to overcome. Only after aiming should you fire the cannonball – dedicate a heavy amount of resources – on a project or idea.
• Conservatism: Plan for the worst, hope for the best, as they say. Collins calls it “productive paranoia.” Planning and strategizing conservatively – as if something will go wrong – gives you options whether events turn out in your favor or against. If you bring extra oxygen up the mountain, you can choose to wait out the storm and try for the summit tomorrow, instead of being forced to either fail to achieve the goal or die trying due to impossible conditions.

Smith’s blackjack ploy makes for great print, but many a company has died relying on that kind of luck explicitly or implicitly. In business and in life, assessing and planning for risk helps us survive and thrive through uncertain times.

Ahhh, economics. The dismal science.

The problems with economics are many. It’s not an observation of immutable natural law like physics or chemistry. Nor does it heal the sick like medicine. Heck, it doesn’t even inspire or entertain like literature or music. Perhaps that’s why it’s the black sheep of the Nobel Prize family… whereas Physics, Chemistry, Medicine, and Literature have their respective Nobel Prize in ______, economics has The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, named as if Nobel were posthumously trying to distance himself from the field and could only barely tolerate his name being tacked onto the prize at the very end.

Okay, it’s easy to make fun, but I do it from a warm heart. I love economics, or at least, what economics has evolved into over the last several decades as the field began to question one of its oldest, most defining, and most impractical assumptions. They say beauty is in the eye of the beholder, so let’s behold some history and see whether you think it’s lovely or ugly.

See, classical economics tends to assume rational agents, operating with perfect logic to maximize their value from an economic system. There’s even a name for this concept – Homo economicus – the Economic Man who behaves with flawless rationality to optimize his outcomes.

To paraphrase from the sage wisdom of the flop 2002 kung fu parody Kung Pow:

I’m sure on some planet your assumption is impressive. But your weak link is: This is Earth.

Real people don’t always behave rationally. Even when doing so is fairly simple. We had a phenomenal example of this in JC Penney’s change to pricing strategy in 2012. Remember that? They ditched the fake “sales” and went with “fair and square” prices, where they simply listed a regular price instead of the same price listed as a “sales price” against the inflated “normal value.” Sales plummeted, and they abandoned the strategy. Homo economicus would not care whether a $10 shirt was on sale from $40 or whether it was always just a $10 shirt. But Homo sapiens looooove a deal. Brand value and loyalty, pricing and marketing strategies, and much more of those business “tricks” exist because humans aren’t purely rational. Studying them as if they are is foolishness.

From this realization, the field of economics started to evolve. It took some inspiration from psychology, sociology, and neuroscience, and put the “human” back in economics, morphing into behavioral economics. It creates the same kinds of economic models as the classical version of the field, but makes some adjustments so that the models work for humans as opposed to emotionless robots.

Why in the world am I telling you this? Let’s step back a minute and take a question I received from a reader:

A question regarding the revenue, income and cash flow and the customer… at what point does the customer point to these numbers and say “enough is enough” and ask for discounts on the product we supply?

 There seems to be a happy medium where you are keeping the investors happy, but still keeping customers happy with acceptable prices for your product. Not sure if there is a universally accepted sweet spot. Maybe the answer is not quite that simple.

 -Dustin Tireman

Good question, Dustin. I’ll give you the simple, classic econ answer, and the more nuanced, completely unscientific, Travis’ behavioral econ answer and let you decide what you prefer.

Classical economics would basically have a chart for you to build or reference. It might be complicated, but it would tell you the exact optimal price to hock your product at. Something like this:

Yawn.

These kinds of things have their uses, conceptually and practically. But it’s not the final, “real” answer in the real world that we occupy. With physics, you can break out a calculator and determine how far a ball will fly or how much weight a pulley can lift if you have enough information. Business is messier. It’s both the beauty, and the curse, of business studies. There isn’t an equation to give you an exact answer.

That isn’t to say there’s not a strong, rational component. Our customers can calculate the cost of buying our product from us versus making it themselves. If we can sell a product for $100 and make a $90 profit, but it would cost our customer $500 to make it themselves, that’s an easy sell. They don’t care about our 90% profit margin, because it’s still an 80% discount to the alternative.

But that’s where the human side comes in. If they know that we make 90% profit margins on what we sell to them, they’ll raise an eyebrow. They’ll know it’s possible to do it much cheaper, and they might invest in the ability to make their own stuff or look for another company to buy from at a lower price.

What could we do to avoid that? Well, we could adjust our prices to a lower margin, sure. We could also prevent them from knowing exactly how much profit we get on those products. One way to do that would be to aggregate products across the business into a more central margin, so that the whole picture looks more equitable. We might still sell some products at a 90% margin, but if the customer is happy paying that, and across our entire business they see a fair margin, say 12%, they won’t dig into it. This creates the tug of war between information we legally have to disclose to shareholders and information we will absolutely never disclose. Corporate margins that include a rollup of all programs, we have to publish. But we will never publish margins on a specific program or product if we can avoid it, because it open the window for that critical eye to whittle our profits down.

And doing this is not deceptive. Every time you go to the store, you know you’re paying a profit premium. Whether you buy a pair of pants, a bag of oranges, a car, a television, you know that you’re paying some company more than they paid to make that. But if you think it’s a fair price for whatever reason, rational or otherwise, you’ll buy it. If not, you won’t. Win-win.

So, the “behavioral” answer to optimal pricing in the real world isn’t so much an equation or a chart (though they may be helpful), it’s more conceptual. Your price should be:

• Greater than the minimum amount you would be willing to do business for
• Less than the amount that would piss your customers off enough to walk away

The grey area in between? That’s business.

Beautiful? Ugly? I’ll leave that for you to behold.

It’s been an interesting quarter in the business world. I decided to write about mergers and acquisitions fairly soon after my last lesson, and the universe granted my wish and provided a whole host of relevant pairings to talk about, running the gamut from monumental (AT&T acquiring Time Warner) to mundane (high-end computer peripheral company Razer purchased THX – you know, the “Deep Note” people you remember only when you go to the movie theatre). In fact, in preparation for this post, I gathered half a dozen interesting M&A stories from this quarter alone. Maybe it’s a hot quarter for it, or maybe I’m falling prey to the frequency illusion. Either way, here’s some of what’s going on around us:

• AT&T purchasing Time Warner
• Various suitors look into buying Twitter
• Bass Pro Shops acquires Cabela’s
• Tesla offers to buy SolarCity
• TD Ameritrade buys Scottrade
• Dick’s Sporting Goods buys bankrupt Golfsmith’s assets
• Verizon offers to buy Yahoo
• Razer acquires THX

Mergers and acquisitions occupy their very own segment of the business world, not entirely separate and distinct from the more typical business topics of finance, accounting, strategy, management, and so forth, but not entirely part of them either. While it has tie-ins – companies wouldn’t be interested in going through M&A effort if it didn’t matter financially – it has its own set of benefits and opportunities, as well as unique risks and pitfalls.

In talking about this, I’m stepping into a dark and scary place, so I’m going to keep it as simple and high-level as possible, and provide some threads for you to pull on if you want to sink deeper.

To paint with a broad brush, the two major types of M&A strategies are horizontal integration and vertical integration. In today’s call, you probably heard the terms “horizontal” and “vertical” a number of times. Let’s quickly talk about each one.

Horizontal Integration

A horizontal merger is when two businesses do the same thing, and move forward doing that same thing together. This happens in the auto industry all the time. We build cars, you build cars, let’s see if we can work together to build more or better cars.

The financial upsides of horizontal integration are typically one or more of the following:

• Economies of Scale: since we’re building more product, we can utilize our resources better.
• Increased Market Access: for instance, if Company A was rocking it in North America, Company B in Europe, the new company can expand the combined global footprint.
• Increasing Buying Power: instead of getting the bulk discount for 50,000 parts, we can negotiate a new discount for 100,000 parts.
• Increased Market Influence: by owning more of the market, a company can more readily set prices and expectations; this can be a very powerful tool, so much so that regulatory agencies have the ability to block mergers under antitrust law if they would effectively kill competition in the marketplace and create a monopoly.

As we’ve talked before, generally, doing more business is good. Being more efficient is good. Having more influence is good. All of these things are possible positives from a horizontal merger. However, there are some complexities, both operationally and intangibly. Some of the risks or difficulties in executing a successful horizontal merger may be:

• Cultural mismatch preventing the realization of operational efficiencies. Too much time can be spent fighting two opposing sets of “We’ve always done it this way” to actually integrate the two separate companies into a stronger whole. Mergers are also tough, and can impact morale, resulting in turnover, disengagement, and other problems that are difficult or impossible to put on paper.
• Complexity leading to growth in overhead, rather than reduction. Ideally, going horizontal lets a company manage more business with the tools it already has, but the differences between two formerly distinct companies may be too complex to rectify into a more efficient structure.
• Incongruent dependencies prevent cost efficiencies. For example, Company A can only obtain parts from Company X, while Company B can only obtain parts from Company Y. If their supply or partner bases are overly specific or constrained, it may keep the operations functionally separate after the merger intended to combine them.

Overall, a horizontal merger aims to do more of the stuff we’re already doing well. In the list above, Bass Pro Shops + Cabela’s and TD Ameritrade + Scottrade are clearly horizontal mergers, aimed at gaining market share, market access, and growing the underlying business by doing so.

Vertical Integration

With vertical integration, a company will buy another company at a different layer of the supply chain or value chain. In the automotive world, if horizontal is like Volkswagen buying Audi, vertical is like Volkswagen buying Car Trim GmbH, an interiors supplier and specialist company.

The stated benefits of a vertical merger are one or more of the following:

• Guaranteed supply base: if you own the supplier, you have full visibility into their operations and priorities, and can control their output at a much finer level. This can let you dig into the details of processes that are difficult to obtain or entirely out of sight otherwise.
• Capture margin: simply put, if you’re paying a supplier a 10% profit margin on their parts, when you own the company, you can drive those costs down internally or capture that margin if you continue to supply to other companies.
• Indirect market control: if the supplier also works with your competitors, you can exert more control over pricing and pacing in the market by owning a key piece of the supply chain.

But nothing is ever perfect, or easy, or perfectly easy. Some of the risks and downsides of a vertical merger are:

• Lack of knowledge or experience: familiarity with a supplier doesn’t necessarily translate into mastery of their business. With horizontal mergers, you’re already used to executing that business. Vertical mergers may force you to operate outside of your core competencies, with associated learning curve and costs.
• Rigidity: one of the benefits of having an outside supply base is that you can be fluid with your supply chain choices. If another company is cheaper, or your current supplier sucks, or you can do the job better internally, you can switch over with comparatively less pain. If you’ve purchased a major element of your supply chain, you’ve made an expensive commitment to insourcing, leaving you less flexible to respond to market changes.
• Difficult integration: as with horizontal mergers, or any merger for that matter, realizing the purported gains can be very tough, for a wide swath of reasons.

With a vertical merger, we want to go deeper into our business, not wider. AT&T + Time Warner is an example of a vertical merger – AT&T distributes content, Time Warner creates it. Verizon + Yahoo would be similar. Dick’s Sporting Goods + Golfsmith is another example, even if the bankruptcy element makes it a bit different.

Further Reading

The further this series of mini-lessons goes, the more complex it seems to get. My goal is always simplicity, and mergers and acquisitions are just one of those topics that aren’t simple any way you slice it. In spite of the title, while some mergers are well-received and mutually supported, there’s a whole genre of them that is bitter and painful. Often, major players in one or both companies disagree on the benefits, and it can be a nasty process to execute the merger or acquisition itself, much less successfully realize the stated gains. Nonetheless, I hope this has been a good first pass to get comfortable with some of the common terms thrown around in that realm and an understanding of what we’re trying to accomplish when we pursue M&A activity.

If you want to learn more, Investopedia has some really good articles that could easily lead to a 10+ tab session of Chrome if you want to dig a little deeper into this world:

• The Wonderful World of Mergers
• The Basics of Mergers and Acquisitions

It seems like in every line of study, there’s one big cautionary tale that gets told over and over across the years to highlight the dangers inherent in the field.

In my undergraduate engineering program, it was the Challenger disaster. We studied Thiokol engineer Roger Boisjoly and his objections to the cold January launch that resulted in one of the most high-profile and devastating engineering disasters of the space era. We used the Challenger story as a jumping off point for discussions on engineering ethics and the importance of clear communication (see: Richard Feynman famously dropping rubber into ice water). It was a formative topic on what can happen when mistakes are allowed to pile up and compound.

In my business program, the ethical investigation centered around one of the most high-profile, devastating corporate collapses in history: Enron.

At the turn of the century, Enron was a burgeoning corporate darling. They were winning awards for innovation, making massive gains in share price, and aiming to take over the entire business world with their ever-expanding markets in energy and beyond. Their shares hit an all-time high price of $90.75 in the summer of 2000, but by the time we opened Christmas presents in 2001, just a single year later, Enron was dead. Over the years, investigations into what in the world happened at Enron revealed a complex web of financial misrepresentation, outright deception, and absolutely deplorable behavior from the very bottom ranks all the way up to the C-suite.

So that’s the playing field. There’s a lot to say about Enron, and many different perspectives we could take. But this isn’t Travis’ Corporate History Corner or Travis’ Business Ethics Forum, it’s a “finance mini-lesson.” Even restricting ourselves to that vantage point, there’s plenty to learn from here.

I’m always talking about how financial data is useful for answering real, interesting questions, and not just deciding whether or not to shed your company stock. Today, we’re going to take a critical look at Enron’s financial reporting and follow the breadcrumbs that led a handful of corporate analysts and business reporters to begin unwinding the web of lies that supported Enron. Using what we’ve learned previously, would you be able to spot these irregularities and see through the shining public image of a dubious, faltering giant? Let’s find out!

While there are heaping piles of figures we could look at to illustrate Enron’s financial woes, we’re going to look at just three. While they’re three of the most basic, which should be accessible to long-time readers of these lessons, they’re also three of the most telling, quickly highlighting Enron’s problems using a strictly numbers-based approach.

Much of the supporting material for this post comes from the publication “Red Flags in Enron’s Reporting of Revenues and Key Financial Measures,” from Bala G. Dharan, PhD/CPA, and William R. Bufkins, CCP. The full report can be found here: http://www.ruf.rice.edu/~bala/files/dharan-bufkins_enron_red_flags.pdf

I suggest the full report for further reading.

Let’s begin.

1. Gross Margins

In the lesson What’s in a Margin?, we discussed the three most prominent types of “margins” used to assess a business’s health, and what each of them means individually as well as within the context of the full set. In that lesson, I said:

Gross margin corresponds with the strength of our business model.

Keep that in mind as we look at Enron’s top-level margins from 1996-2000:

Here we see massive revenue growth over 4 years (almost ten times!), but anemic gross profit growth (just over two times). This is shown in the steady dilution of gross profit margin. Many businesses highlight revenue as a key figure in showing health, and Enron was the standard-bearer of this metric. They bragged about all the markets they were entering, how much business they were doing, and just look at that revenue growth – 251% in the year 2000 alone.

I feel like maybe I’ve downplayed the importance of revenue in the past. Revenue is the start of everything. Increasing revenue means we’re doing more stuff, and doing more stuff is usually a good sign. It’s a catalyst for growth and a sign that there’s demand for our business in the marketplace.

But remember, gross margin shows the strength of our business model. If revenue is increasing, it means we’re doing more stuff, but if our gross margins are declining, it just means we’re doing more of the wrong stuff. Enron’s obsessive focus on increasing revenues and showing off revenue growth served to distract from the very obvious fact that their growth was not healthy or profitable.

Gross margins should have been the first sign of this, but operating and net margins also showed massive declines as the Enron bubble inflated.

2. Cash Flow

We’ve talked at length about the importance of cash in a business. At the end of the day, profit is just a number on a calculator, but cash moving in and out of the corporate coffer is real.

Here’s where the more direct manipulation from Enron’s top brass comes into play. Mysteriously, they focused on ensuring that annual cash flows showed positive, while leaving breadcrumbs in the quarter-to-quarter results.

Check out the cash flow from operations quarterly data for the year 2000:

In earnings analysis, adding “from operations” to any figure basically means focusing in on the core business. Big companies, especially publicly traded ones, have a lot of things going on financially. The “from operations” designator says “this figure is from repeatable stuff accomplished from our core business operations, rather than discontinuous activities that might vary over time.” This makes it especially important for analyzing growth trends and assessing the company’s place in the market.

On the table above, you can see Enron absolutely hemorrhaging cash from their continued operations in the first two quarters, then executing a somewhat realistic (but impressive) turnaround in the third quarter and a… wait… what in the world… your cumulative cash flow going into Q4 was $100M and you ended the year at almost FIVE BILLION?

You would have to grow extra eyebrows to be able to raise enough of them at this figure.

3. Investing Activity

In the last section, we saw that there was something fishy about cash flows. Now, we’ll look at how that manipulation was accomplished. Top-level cash flows were controlled in two primary ways: debt and equity.

Taking on debt is a positive source of cash with an offsetting liability. You get cash now, but make payments along the way. But those are on different pages of the financial report so you can try to hide it by squirreling away debt on the balance sheet and highlighting your awesome cash flows. Very novice level ratio analysis would uncover this, but Enron had a strong façade, dissuading critical inspection. To give analysts some credit, Enron additionally cheated this system by hiding its debt in an unending stream of special purpose entities and shady shell corporations that were nearly impossible to unravel.

Equity is using your shares as a financial device and issuing stock, which dilutes per-share value but gives you immediate cash. As we’ve talked before with share repurchases, selling more shares is generally not a good sign; it means organic growth isn’t proving sufficient to support the business. Because Enron’s shares were valuable, they had easy access to equity cash, since banks were of course happy to be part of the rampaging Enron train and investors were gobbling up the vogue stock of the time. So, Enron had cash because its shares were valuable, and its shares were only valuable because they had access to cash… which came from selling shares… see the house of cards being built here?

Both of these activities, as well as some other more complicated ones, are what we would call investingactivities, which are separate and distinct from operating activities. Remembering how operating cash flows are critical in highlighting core business performance and trends, check out what happens to Enron’s total cash flow (from both sources) when the investing component is taken out:

Blam.

Oh, and the positive $515M in 2000 actually ignores $2.35B in repayments to California utility customers, so that one should actually be negative $1.835B. That’s over eight billion dollars in cash lost by the business segments that Enron claimed were making it rich.

They were supporting themselves strictly with debt and equity issuance, while bleeding literal billions out from their meager operations – operations which, despite a ton of media hype over big, tenacious projects, were anemic at best and pure, uncovered losses at worst. Famously, they had used sneaky accounting to book millions in future profits on a power plant that never once turned on. And that was just one of many instances.

We’ve covered a tiny sliver of the insanity that was Enron. I hope this has been an illustrative and informative look into an applied use of finance that some might call forensic accounting. If you’re interesting in learning more about the fascinating, though tragic tale of Enron, I strongly suggest the documentary Enron: The Smartest Guys in the Room. It’s currently available on Netflix. Additionally, for a bit more depth on the financial side, check out the report that I referenced for this lesson here.

Two mornings of every week, I pull into my local McDonald’s and order the same thing: an Egg White Delight McMuffin meal with an iced tea and a Fruit ‘N Yogurt Parfait. Not a bad breakfast healthwise – the whole thing is 550 calories including a hashbrown (the worst offender) – and it clocks in at $5.79 for a tasty, mostly health-conscious breakfast a couple times a week. But for the past few weeks, I’ve been getting a bonus with my meal. Along with my balanced breakfast, I’ve been racking up a lot of – you guessed it – McDonald’s Monopoly pieces.

On the breakfast bags, McDonald’s claims there are “100 million food and cash prizes!” Note that according to what they’ve posted on their rules website including odds of winning, they’ve actually undersold it quite a bit. According to their posted rules, there are actually 131,907,433 winners (132 million vs. 100 million), with a total prize value of a staggering $353,480,757.77. Yes, three-hundred and fifty-three MILLION dollars. See the results spread below:

Aha, now you see why this is relevant to corporate finance. McDonald’s is a big company, but $350M is a significant amount of money for most businesses, even ones of good size. In these lessons, part of my goal is to emphasize that finance and accounting can be both useful for answering questions about what businesses do and interesting in the kinds of things you can uncover with it. Let’s see what else we can learn about McDonald’s longest running and best-known promotion.

Monopoly, like the infamous McRib, seems to be deployed when needed or convenient throughout the year rather than consistently on a set schedule. In 2013, it ran in July, in 2014, October, and in 2016, April. In 2015 Monopoly wasn’t run at all in favor of a November cross-promotion with the NFL called Game Time Gold, which for convenience I assumed utilized a similar payout structure. This makes it a little bit hard to see in the financials exactly how the major promotions affect earnings, but we’ll do our best to try. Side note: if you happen to know where I can find historical Monopoly runtimes, hit me up, I’d like to expand the range of my data and apparently my Google Fu isn’t strong enough.

The chart below shows revenues, operating income, and operating margin for quarters before, after, and including these promotions (yellow). Let’s check out the results and discuss them below.

Alright so, McDonald’s was having a tough time in 2014 and 2015. What we see in 2014 is pretty dire – the trend across these three quarters is almost linearly downward. But how does the Monopoly promotion affect its quarter? Well… it doesn’t look like it does. Yeah, it’s down from the previous quarter, but it’s right between that one and the next one on all three parameters – sales, earnings, and margin. In other words, at worst, it did nothing, but at best, it arrested a trending loss of revenue and earnings that was realized in the following quarter. Big promotions weren’t a major enough factor to overcome other trends, positively or negatively.

2013, however, was an absolutely beautiful comparison. The quarters before and after Monopoly ran were practically identical on all three components. The quarter that Monopoly ran in showed over 3% gains in revenue and a 10% upside in earnings, making for a 2% boon to operating margin.

Now, for any of these quarters, how much impact would $350M of free food have? I took the simple average of these 8 quarters for revenue and operating income, calculated a margin, and then hacked $350M off of operating income to represent giving away that amount of free food with no additional revenue. The results:

If there wasn’t some positive impact to the numbers, the Monopoly prizes would absolutely hammer earnings, with operating margin diving nearly 20%. It’s probably not surprising to anyone, but McDonald’s is not losing money on its promotions. At the very least, it’s not losing as much as it should be without secondary positive effects. You’d also expect them to not run it for 20 years unless there was a benefit. Case in point, how does the company view the game? The 2013-Q3 report mentions Monopoly specifically. Well, for a sentence anyway. All we get from the company in the quarterly report is, “Sales results for the quarter were also positively impacted by the popular Monopoly promotion.” If there wasn’t some level of offset against the free stuff they gave away, you’d expect some statement like, “Operating income is down this quarter as we gave away $350M worth of free food during our Monopoly promotion in order to… I dunno, build brand value or inspire return customers or something.”

So why does a promotion that puts $353M worth of prizes in circulation (99% of it in free food) appear to make the company money, or at least, not lose as much as it should? Several factors may be at play here:

• Not all of the winning tickets are actually bought, or looked at, or recognized. Boardwalk is famous, but what are the other rare pieces? Would you know them if you got them? (Helpful hint: it’s the last piece of each set alphabetically, except for Boardwalk)

• A small percentage of the food prizes are actually claimed.

• The food prizes, even when claimed, are an excuse to spend even more money.

Unclaimed Monopoly winners is a non-factor; the total amount of available cash prizes from collecting pieces is less than $2M, which for McDonald’s really is a drop in the bucket. The last two are probably significant, but I suspect the last one is the real cause of the difference between claimed prize cost and actual financial results. If you win a Quarter Pounder, you’re not going to just go in and get one. You’re going to go in and spend the same amount of money that you usually do, plus a “free” Quarter Pounder. You’re not going to eat that Quarter Pounder without a Coke right? And of course you wouldn’t go to McD’s without getting some hot, salty fries. And since you saved money on the burger, why not top it off with a McFlurry? Most of the loss of the “free” items is probably entirely compensated by additional purchases when people cash in winning food tickets, resulting in straight upside for the company. After all, look how abysmal the odds and total amounts of the cash prizes are, and how prevalent the food prizes are. The tiny chance of winning cold hard cash brings you in the doors, but then if you win food, you’ll come back and buy more. To borrow Monopoly parlance, by giving free food away, McDonald’s rolled doubles and gets to take another turn. This is why in the more ideal 2013 comparison, and in the Q3 results, the benefit of Monopoly is seen: increased revenue, without impacting margins.

Now, make what you will of this. Just because a company is making more money doesn’t mean they’re doing something evil. In the sometimes idealistic world of MBA-land, “marketing” isn’t akin to “manipulation,” it’s responding to markets and giving people what they want, often in what we might call mutually beneficial ways. After all, it’s not like McDonald’s is selling lottery tickets here; you’re not getting vague, conceptual “hope” and nothing else for your money. You still get your food for the same price as before, plus the added fun of peeling off and collecting game pieces. An economic description might say that you give McDonald’s more of your money during promotions like Monopoly because you get added value for the same price, shifting the value proposition in favor of the customer, or generating additional consumer surplus. I could throw more terms at you but you get the picture. Of course this works in McDonald’s favor too, since they enjoy added revenues and profits.

Let’s quickly look at another great example of this mutually beneficial marketing from the fast food realm. First, let’s think about the busy-ness level (volume) of a typical fast food restaurant. Well, there’s probably a breakfast crowd, peaking maybe 7:00-9:00 a.m., a lunch crowd between, say, 11:00 a.m. – 1:00 p.m., and a dinner crowd between 5:00-7:00 p.m. This is rough guesswork, but it’s reasonably accurate for general purposes.

It’s easy to spot the downtimes. Downtimes are problems, especially for a low-margin, high-volume business like fast food. There are lots of financial reasons for this. For one, fixed assets like buildings and utilities are sitting underutilized when they could be making money. Inventory isn’t turning over (insert burger flipping joke) and making money, it’s just sitting. And even though you can maybe staff less during downtimes, if you’re open for business you’ve likely got someone being paid to twiddle their thumbs. All told, it would be better to be able to fill those gaps. But we’re not really going to inspire people to eat a fourth meal… what could we do?

Cue Sonic’s Happy Hour promotion. From 2:00-4:00 p.m.,　 customers get half-price drinks. To sample the efficacy of this idea, drive down the street and look at how busy the fast food places are at 2:00 p.m. Then pull into Sonic. With a little creativity, Sonic has filled a huge gap in their daily productivity. And by doing it with drinks, which are probably 90% profit to begin with, they’re bringing in material additional revenue and earnings, not just utilizing fixed assets to keep them moving. Add in the fact that people coming to Sonic for drinks will be tempted to get a snack, and you’ve effectively created that elusive 4^th meal (sorry, Taco Bell, we didn’t buy your midnight 4^th meal). Sonic made this temptation even more palpable in 2013 when they added $0.99 snacks to Happy Hour. And they didn’t stop there… Sonic has another promotion so customers get half-price shakes after 8:00 p.m. What a coincidence that this time also corresponds with a slowdown between dinner and closing. It usually only runs in the summer too, when more people are likely to be out later due to nice weather, daylight savings time, and school breaks, and are more likely to want a cold milkshake to battle the heat or finish off a summer date night. I’m not getting kickback from Sonic on this, it’s just freaking brilliant how seamlessly they implemented these business catalysts. And they did it in a way that people love!

What’s the takeaway from this? Well shoot, I just wanted to learn how McDonald’s fares on Monopoly. But maybe I can drum up something…

There’s a lot of negativity in the modern zeitgeist regarding corporate profits, sales, marketing, and business in general. Yes, there are sleazy or cheap methods of selling. Overhyping, fearmongering, clickbait headlines, sexual content, proprietary ecosystems (critique of Apple), and fine-print restrictions are all ways for companies to manipulate consumers by legally getting away with outright lying or by artfully deceiving the careless. BUT – there are also perfectly honorable and noble ways of selling that benefit the customer and the company. Innovation, beautiful design (praise of Apple), superior value, superior quality, superior support, cool factor, unique utility, and yes, even fun are ways to increase sales and customer participation while simultaneously increasing customer satisfaction.

So, yeah, be skeptical and look out for sleaze. It does exist. You owe it to yourself to learn the bottom-feeder sales and marketing tactics in order to avoid being taken advantage of. But you also should recognize and reward the good side, and if you’re creating a product yourself, implement some of the positive approaches to marketing in order to ethically increase your value.

Alright that’s all I can shoehorn in. Hopefully this has been an interesting look at a couple of things and has given you some things to think about. In the meantime, I’m off to go cash in a free Quarter Pounder piece… and maybe buy a McFlurry to go with it.

There are two basic types of accounting. What you’re probably most familiar with is called Cash Basis. In Cash Basis accounting, the amount of money left over at the end of the accounting period is the “profit,” or possibly “loss” if it’s negative. This is most likely how you do your personal finance. You may not think of it as accounting per se, but it’s keeping track of where your money goes over time, hopefully so you can make good choices with it, same as a business wants to do. Your bills most likely occur each month, so it makes sense to plan around how much you’ll make that month (your personal “revenue” line), then deduct out bills (“expenses”) and choose what to do with the rest – save, spend, invest, etc. There are only so many fundamental things you can do with money, and your list – spend, save, give, invest – is the same as a business.

Cash Basis is used in the business world, but it’s exceedingly rare, perhaps absent, among publicly traded companies. Instead, they Accrual Basis. With Accrual Basis, revenues are counted as they areearned and expenses counted as they are used. Why? Companies almost always have big investments that need to be made that would distort the trending performance of their business. The simplest example is a building. If a company buys a 100 million dollar building, it’s going to destroy the quarter they did that in, because it’s a huge one-time expense. But then, as they use the building, it seems to be free – until they have to do maintenance, or expand their property, or anything else. Cash basis would result in huge spikes and dips in profitability, and wouldn’t really represent the ongoing nature of business. Instead, Accrual Basis would depreciate their owned assets as they’re used, smoothing out the cost of a building, or expensive equipment, over the course of its useful lifetime. That lets us compare the cost of the stuff against the revenue that it helps us generate over time. This is actual, useful, relevant data.

There’s no question that Accrual Basis is superior for most businesses of reasonable size. There’s also no question that it leads to some interesting complexities that can confuse people without an accounting education… like, you know, most of the employees of most businesses. In today’s lesson, I want to talk about just a few of these concepts that seem to “distort time.” Hopefully after this, you won’t have to ask yourself, “With all these deferrals and catch-ups and depreciations, what actually happened this quarter?” It really does make sense, but you can’t be blamed for thinking it’s not clear. Let’s work on closing that gap, using a few common time-distorting concepts to illustrate.

Deferred Revenue

Another named for Deferred Revenue is “Unearned Revenue.” All this means is that somebody paid us in advance for work that we have yet to do. We don’t want to account for it in our profits and cash flows just yet, because it would make the quarter we were paid in look really good, but then as we do all the work over a number of quarters, it will drag all of those quarters down. This is a good reason to generate an “Adjusted” figure to better represent the trend, rather than all the ups and downs that are more random. See the example below:

Here, we’re paid $192M up front for work that we have yet to do. Sure, we’re heavy by $192M in cash, but if we account for it all now, we’ll be appearing to do work “for free” over the next several quarters. We chose a slightly annoying time distortion by using deferred revenue over a performance wrecking cash-basis method where we would have a big quarter now, but be $50M worse off for each of the next 4 quarters.

Just to even things out (like in all math, your equations have to balance), we will add $192M worth of liabilities to offset the advanced payment cash. Liabilities are most often thought of as debts; all debts are liabilities, but not all liabilities are debts. Some liabilities are services that we have to provide, as in this case. See below (read right to left for chronological order):

You’ll notice that the difference isn’t exactly $192M, since this is the growth in deferred revenue over a whole year (Dec 2014 to  Dec 2015), but that $192M is in there prominently. Since that revenue is considered a “liability,” we can claim it as a benefit whenever we feel appropriate by reducing the deferred balance to equalize whatever gain we want. We’ll use this to claim profits as we actually produce the products we owe the customer, resulting in a more accurate depiction of our performance on each unit.

Deferred Inventory

Alright, deferred revenue was the slow pitch to start. Another major type of deferral that we hear about often is Deferred Inventory. This one is a bit more complicated… I’m gonna have to use a shoddily hand-drawn graph, so buckle up.

Deferred inventory is a feature of large-scale manufacturing. In the earnings calls, you’ll hear a lot about “accounting blocks” and “learnings curves.” This is because the first time you make a massive, high-tech product like an airplane, well, you kinda suck at it. We do our best to estimate how many units need to be produced before we start sucking a little less, then a little less, and so on, until we really hit our stride. Each of these ranges of less-suck-ness may become an “accounting block.” As in, we really suck on units 1-20, suck a little less on 21-40, and after 100 or so we’ve actually gotten pretty reliable and good. This is because we’re progressing down the learning curve over the entire course of production – across and within accounting blocks, we hope to be getting better at what we do.

When we take on a major project, we’d ideally like to estimate the overall profitability of the entire program. From beginning of design to last unit off the press, how much money will our company make? Those estimates exist, and deferred inventory, along with forward losses and catch-ups, is how we adjust those estimates to reality. Let’s dig deeper.

So what is deferred inventory? Time for the first shoddy drawing:

In a sentence, deferred inventory is the difference between how we really performed and how we expected to perform. Our estimate for line unit (S/N is for serial number above) 12, say, is based on some assumed learning curve. If unit 12 costs more than we expected it to, that overrun is unit 12’s deferred inventory. It’s added to the deferred inventory balance for the program.

Deferred inventory will metaphorically sit there and rot (unlike physical inventory, deferred is “just a number”) until we make a unit that costs less than estimated. If we do better than expected, it reduces the deferred inventory balance.

Now the trickier parts. If we believe we will never, over the entire course of the program, make gains that will deplete some of the deferred inventory, we have to write it off as profit we won’t ever earn. This is what’s known, affectionately, as a “negative cumulative catch-up,” or “forward loss.” The counter to this is the positive cum. catch, in which we beat estimates by more than we ever thought we would, and we can write additional profit.

Hopefully, that helps clarify what’s really going on when the analysts and executives talk about growth in deferred inventory, or deferred cost per unit. They’re talking at the absolute highest levels of any program. The deferred inventory balance is a measure of our overall performance on a per-unit, or at least per accounting block (several unit) basis. And the forward losses/catch-ups are adjusted profitability for the lifetimes of whole programs. So it’s quite a big deal.

Again, if it seems confusing, or manipulative of the numbers… well, it is. But it’s the best way to resolve some of the complexities of accrual basis accounting applied to large-scale manufacturing, and accrual basis really is the superior method of accounting for large businesses. It’s not complexity for complexity’s sake; it’s complexity that exists to represent reality as best as possible in a very complex situation with many moving parts.

Depreciation

Okay, so the heavy stuff is over. Let’s look at one more quick example and call it a day. One of the big three financial statements is the Statement of Cash Flows. It can be a little weird the first time you encounter it, because it works backwards from net income, adding back in expenses until you get to cash flow from operations. In other words, you’re adding money you spent; ordinarily you expect to subtract it.

Whatever. There are two basic kinds of costs in business: variable and fixed. Variable costs are those that depend on how many units are being built. Simplest example? Hamburger patties are a variable cost. You need to buy one patty for each burger you sell. Fixed costs are the “barrier to entry” items. The grill you cook a burger on is a fixed cost. You need it to get in the game.

Each type of cost has its advantages. Variables costs are nice because they’re flexible. You can get exactly as many burger patties as you need. On the downside, you don’t ever escape those costs. The variable cost of burger #1 is the same as burger #1,000,000. Fixed costs kinda stink because they’re often costly up front, but they benefit massively from repeated use. A grill makes burger #1 very expensive to make (cost of a patty plus an entire grill), but by burger #1,000,000, the fixed cost component gets divided out over a million units and is basically free.

When businesses have to make big, expensive, up-front purchases like buildings, machinery, tooling, equipment, etc., it can absolutely wreck their financials for the period in which they bought it. So, while the cash hit happens whenever cash changes hands, the profit can be smoothed out using depreciation.

There are many different methods and approaches to calculating depreciation, but it doesn’t really matter for illustrating the point: by “distorting time” with depreciation methods, the overall trend of profitability can be shown instead of a huge loss up front followed by gains. If the restaurant estimates that their grill will last 5 years, they can assume reasonably well that by depreciating the grill’s cost over that time frame, they’ll get a pretty accurate measure of profit as they move along. Depreciation prevents burger #1 from showing up on the profit and loss statement as costing $600, and instead makes each burger, from #1-#1,000,000, cost about the same.

While accrual basis accounting can have some funky features like those listed above, you can pretty easily build a case for its superiority for larger businesses. If something doesn’t make sense, look for how it affects the timeline and the trendline of the business. And if you can’t quite figure it out, well, you can always defer the topic to another day.

Ever since I started writing these mini-lessons, I’ve focused on the importance of cash flow, cash reserves (savings), and cash utilization. And while these are certainly vital topics in understanding ongoing corporate finance as well as business growth (and its limiting factors, in the case of “Can a Company Grow Too Fast?“), there is indeed a flip side. Many companies never achieve the financial breathing room required to even wonder if they have “too much” cash, and while it’s a much better problem to have than not enough, a large enough stash can indeed be a negative for a company’s finances. Today, I’ll share a couple of reasons why that’s the case.

1) The company isn’t reinvesting in itself enough

In many ways, corporate finance can be understood using similarities to personal finance. In personal finance, it’s always good to have an emergency fund. You want to save up a financial cushion for when a car needs repairs, when the air conditioner goes belly up, or someone is unexpectedly let go. Savings are wise not only for emergencies, but for general liquidity — a “finance-ese” term for being able to access cash easily for whatever reason.

But cash, even though it feels good and secure and stable, is a terrible vessel for large percentages of your money. Due to inflation, cash actually declines in value over time. Even if it were stable and never lost value, almost nobody has both the income and the financial discipline to save 50% of their earnings for retirement. Once you’ve built up some emergency cushion and some “general liquidity” savings, there are better uses for your money. Debt should be paid off, because it works against you at whatever the interest rate is. You should also invest, since over the long-term, good investments will outpace inflation and actually make you money.

For companies, it’s very, very similar. Cash is great, because companies have emergencies and experience unplanned events just like you do in your personal life. They also get opportunities for things to buy that might not be necessary, but that are beneficial to have.

But at some point, that cash is just rotting away when it could be doing something. In the case of a business, that “something” is usually obvious: if we put that money back into the business, via equipment, or marketing, or personnel, we would expect to get a rate of return equal to our profit margins on that money. Or we have debt that, just like personal debt, works against us at whatever the interest rate on the loan is.

Cash for the sake of cash is worthless. If it’s not protecting against the unknown or allowing rapid response to emergent opportunities, it might as well be put to use to eliminate debt or invest in endeavors with some level of return.

2) The company expects a dimmer future

Last summer, when I was young and naive and finishing my MBA, I learned about the “harvest strategy.” The harvest strategy is employed when a business (or part of a business) has matured to a point of saturation, and there is little or no growth opportunity remaining. In this case, reinvestment is foolish; there’s no growth, market share, or profitability to be gained by pouring extra cash in, so instead, we’ll just rake in the rest of what we’re making and move on. In the case of diversified companies, that money might be channeled into another product line or division. In the case of small companies or those specific to a single product or industry, they may just save up the cash until they close the doors and withdraw their wad.

If industry, market, or competitive trends remove the benefit of reinvestment, cash becomes a more attractive option. Cash also becomes a more attractive option if the business is souring. Most likely the only reason my dear BlackBerry still exists today as an independent company is because ex-co-CEO Jim Balsillie kept the company debt free and cash rich (for an interesting business biography on the rise and fall of BlackBerry, I recommend Losing the Signal, by McNish and Silcoff). Again, using similarities to personal finance, if your company has announced layoffs, it can be prudent to save as much as possible in order to deal with the temporarily heightened uncertainty.

However, both of these options are reserved for companies in decline. If a company’s cash reserves are growing and analysts are asking what the plan is, you want to listen closely. The responses can indicate what the leaders of the business think about their future — vital information to anyone interested in the company, from an investor or an employee standpoint.

3) The company becomes a takeover target

There are about a thousand similes I could use here to illustrate this, and none of them are particularly kind, so grant me some leeway. At times, big companies can be like schoolyard bullies. If they see a smaller kid carrying around a lot of cash (or maybe a particularly desireable lunch), they can strongarm the victim and use it for themselves. Sure, they could pick on a kid with a nice, expensive backpack or a pair of high-end shoes that they could take, resell, and come out with the same gain, but that’s a whole lot more work. If they can get what they want directly, it’s to their benefit.

That’s a weaker analogy than I usually come up with. Sorry for my shortcoming. Big companies are not necessarily mean-spirited, and takeovers are not necessarily hostile or singly beneficial. But hopefully it’s good enough to illustrate the point.

If a company has too much cash, due to underutilization, declining business, or just lack of direction, well, somebody else can use that money better. Instead of letting it waste away in the corporate coffers, they’ll put it to use. In fact, since they’re the new owners of the company, maybe they’ll just reinvest it to get returns equal to the company’s margins, as mentioned before.

Apple is famous for its cash hoard, but then, they’re also basically immune to takeover at this point because of their growth rate and profitability, as well as their multiple hundred billion dollar valuation. But a small or medium company with a big loaf of cash can start looking really tasty to bigger fish.

4) The company isn’t rewarding shareholders

A top goal for any company is to make money for its owners. If the company is publicly traded, that means that the owners of its stock are the “real” ultimate owners of the business. While it’s in everybody’s best interest for the company to keep enough money to operate and grow, at some point, if the business is working well, some of that money should go back to the owners! Whenever the fundamentals are in order and the company clearly has the income to maintain business as usual and grow at a healthy pace, shareholders will start asking for a cut of the profits they’re entitled to. For a more thorough discussion of some of the ways companies can give back to their shareholders, see this article.

The essence of capitalism is that the shareholders of a public company aren’t just “investors;” the shareholders legitimately own the business. It’s easy to forget, because you probably don’t play an active role in the companies that you’re a part owner of. Do you know how many companies you own a tiny sliver of via your 401(k)? Most investment strategies will include at least one index fund, most popularly an S&P500 fund, meaning you’ve got a piece of hundreds of different companies that you own. While many casual investors aren’t active in leveraging that ownership to make strategic decisions, they want the same thing as the people who are more involved: to make money on their investment in the company. You may not think of it that way often, but if you’re invested in a stock or mutual fund, you obviously want it to go up in value! If that weren’t your goal, you’d have that money in a bank account or a cash/stable value fund.

Different investors have different goals and values. Most are just people like you and me, investing money for retirement or major expenses like college for their kids or a house, hoping that our money is well-placed to grow and flourish in the market. Some are interested in controlling the company’s behaviors by electing members to the board of directors or even inciting proxy fights, where investors who are unsatisfied with one or more aspects of the company can gather up enough votes from other shareholders to elect new board members or convince existing board members to change their positions. Additionally, some investors are concerned with environmental or ethical issues, while others are simply there to maximize profits. Some investors are long-term driven, wanting to hang onto a company for a lifetime, while others want to capitalize on a market trend, boom, or fad, and harvest as much money as possible before dumping the shares. This isn’t an ethics discussion; it’s simply the nature of things that people have different wants, needs, and values that match their financial situations and personalities. Even among investors who are primarily focused on profit, there’s a major distinction between two types. These two types are both wanting the company to “return value to shareholders,” but have different preferences on how it should be done. Today’s discussion is on two major approaches to “returning value,” and the types of people who may prefer each.

Dividends

One way of increasing value to shareholders is to issue dividends. Dividends are cash payments that companies make to shareholders out of their profits. Coca-Cola (KO), a company famous for its long-term dividend policy, will pay investors $0.33 per share, per quarter in 2015.

Typically, dividends are issued by large companies who have limited growth potential. Coca-Cola has nearly worldwide market penetration. Try traveling somewhere where you can’t buy a Coke. As such, they don’t really need to reinvest a ton of their free cash flow. What would they invest it in? They’re a global, stable, cash-generating machine. In other words, they issue dividends because it’s the best way for their company to return value to their shareholders.

So what kind of investor prefers dividends? Conventional investing wisdom suggests that people approaching retirement should shift into more blue-chip companies — big guys like Coca-Cola that probably aren’t going anywhere anytime soon — to protect their invested assets and to replace their incomes with dividends upon retirement. Many retirees look to annuities, where they turn their lump sum investments into regular, steady cash flow to live off of after they stop drawing a paycheck. A dividend-heavy portfolio accomplishes something similar, with greater risk because the stock can decline, but also greater potential since the company can still appreciate in value or increase their dividend payout.

As an example, if someone wanted to make $100,000 annually in retirement, they could do a calculation to see how much Coca-Cola stock they needed to own to produce that. At $0.33 a quarter, each share of Coke makes $1.32/yr. You would need 75,758 shares to make $100,000 in 2015. At the time of this writing, Coke’s share price is $41.08, so to generate a $100k annual income, you’d need around $3.1M in Coke stock. That’s a lot of money, but you can see how dividends could play an integral part in someone seeking to get cash back out of their investments while preserving their value (and even continuing to grow it).

Share Repurchases

An alternative way for companies to increase shareholder value is to purchase their own shares off the market. There are a couple different ways to do this, and some other reasons besides shareholder wealth that companies may buy back shares, but generally, the results are the same: the company’s value stays the same, but since there are fewer shares, the value of each share increases. This directly puts more money in the investors’ wallets.

Here’s an example. Let’s say a company has 50,000,000 (50M) shares on the market at a price of $100 each. The company’s market cap (total value) is 50M shares times $100/share, so $5B. If the company purchased $100M of their shares back, they would remove 1M shares from the market. There are now 49M shares outstanding. The company is still worth $5B total though, so the share price will adjust accordingly — $5B divided out over now 49M shares instead of 50M equals $102.04 per share. The share repurchase gave an immediate 2.04% return on every outstanding share. Not bad for a day’s work! There used to be another reason shareholders preferred repurchases over dividends. It used to be that dividend income was taxed at normal income tax rates, while share appreciation was subject to the lower long-term capital gains tax rate. That changed in 2003 so dividends are now taxed at the capital gains rate.

You might have already guessed what kind of investor or company prefers increasing share value over cash payouts. Not surprisingly, it’s the opposite of the dividend-preferring crowd. Younger, more aggressive investors want share values to increase. They’re still working and investing for the distant future. They want their investments to compound, and they don’t care about cash, since they’re not planning to use it for decades! Also, while large companies with high levels of market penetration are more likely to generate dividends, since they don’t have a lot of growth potential even with massive reinvestment, smaller companies benefit tremendously from reinvesting in the value of the company and its future growth.

The Bottom Line

At the end of the day, when a company exercises either of these options, it’s usually a signal of strong earnings and solid financial standing. Different companies, different boards of directors, and different people will want different things out of their investments. But if your company is putting a high priority on “increasing shareholder value,” it generally means that things are pretty stable on the homefront.

As you listen to your earnings in the future, listen for investors to start calling for these options, directly or indirectly. As I always emphasize, it’s the intangibles that make earnings calls interesting. If your analysts are concerned about the future of the company, it signals one thing. If they’re seeing dollar signs, they’ll start to ask for a piece. See if you can catch it next time you listen in!

For more information on share repurchasing, see: http://www.investopedia.com/articles/02/041702.asp