Understanding how sales growth converts to profits

So firstly, let's understand sales and profits. If we simplify what a business does, it starts with some seed capital. In the business startup phase, there'll be some shares issued, which becomes the equity (startup capital) in the business. They can issue more equity as time goes by, but also they may borrow money by taking out loans or debt to increase the capital they have.

That capital will then be employed in the business to buy, for example, factories or working capital (like inventory for sale) with the intention of generating sales from its products or services.

If the costs are managed adeptly, that business should create profits, but not all profits are created equal. Ultimately, the goal is to generate cash.

Let’s hone in on sales and profits.

What we really want to look for to find potential multibaggers is the ability to consistently grow sales through time. Ideally, sales growth should be higher than inflation, because otherwise the company may be suffering declining sales in real terms. Growing faster than inflation is precisely what Games Workshop did.

Now interestingly, for a few years, the company actually saw declining revenues before there were strategic changes which led to very, very significant revenue growth - signified in the blue bars below. But there was also, accordingly, an increase in the Operating Profit shown by the green bars.

This was a very transformational period in the stock and led to extraordinary share price returns.

Spotting Sales Growth Potential

So, how do you spot a company with sales growth potential? Well, there are three key areas here I would like to discuss.

• Firstly, there is Market Expansion. A company may operate in a big growth market in a single geography, but Games Workshop was in a niche business area and decided to expand into new geographies.

  These new market segments internationally really helped drive the business growth. So that was key factor in this case study.

• New Product Development is often a key part of many businesses’s models. Apple will be releasing its iPhone every year and other products to drive growth, so product innovation can keep offerings competitive and ensure customers upgrade. We've seen that in Games Workshop with all their releases around their Warhammer brand.

• Effective marketing and sales strategies

  . Growing the customer base through marketing efficiencies is very important too. Games Workshop itself had spoken about its strategy for quite some time. It was running low-cost, “one man retail shops” and also distributing products through trade channels, through online portals, and also by licensing.

All these factors had been much discussed even before the big share price move, while the strategy was being implemented. It took the changes in the business financials for the market to wake up to the potential here.

Converting Sales into Gross Profits

So a company generates Revenues if it sells products or services, but a business will have to pay for the cost of those goods sold. This is called, unsurprisingly, the “Cost of Goods Sold” or the “COGS” and shows up in the Income Statement (formerly known as the Profit and Loss Account).

If you can imagine Games Workshop, it would have to pay for the raw materials that go into its figurines and board gaming materials, and the costs roll up into the “cost of the goods” that it's selling. And if you subtract that from revenues, you calculate what’s called the “Gross Profit”.

This is an essential number to understand. Companies that have a high Gross Profit relative to their Revenues (known as the Gross Margin), are often businesses that have some kind of advantage in pricing power.

We found that Games Workshop was able to sustain a 70%+ Gross Margin through time, even as those revenues were significantly increasing. Often you find sustainably high Gross Margin businesses can be “price setters” rather than “price takers”, and if they are growing sales while keeping margins high it’s a good sign, as they are unlikely to be using lots of discounting to drive those sales.

From Gross Profits to Operating Profits

Now, Gross Profits aren’t real profits. The company also has to subtract its operating expenses. It has selling, general and administration costs, there might be research & development expenses, and there may be other expenses that go into that bundle, but generally after you've subtracted both of those, you come to a number called the Operating Profit.

This is the profit after all of the expenses of the operation. If you compare this number as a percentage of revenues, it’s called the Operating Margin. This is one of the most important numbers to understand in finance.

In the next article, we’re going to learn how a company’s Operating Profits can accelerate more quickly than a company’s Sales Growth. This is the great power of Operating Leverage, which can radically drive share price returns.