Would You Expect a Pharmaceutical Firm to Have a Relatively High or Relatively Low Net Profit Margin? Equity Multiplier?

1. Would you expect a pharmaceutical firm to have a relatively high or relatively low net profit margin? Equity Multiplier?

A pharmaceutical company is expected to have a relatively high net profit margin. This is because, pharmaceutical companies derive their source of earnings power from their intangible assets or patents. They have exclusive rights to sell the drugs which owe their allegiance to these patents. Other than the R&D spend and amortisation of intangible assets, pharma companies have no major expense and hence their margins are expected to be higher.

Equity multiplier is defined as Assets as a proportion of Equity. For pharma firms, assets are not of a big size. The biggest pie of assets comprise intangible assets which are internally generated. These internally generated intangible assets are not recognised fully due to accounting conventions. Hence, assets are lower in proportion to equity and Equity multiplier is not big.

1. Explain why NPM tends to be mean-reverting.

According to the Mean reversion postulate, values are driven to the mean. NPM or Net profit margin is presumed to be mean reverting. The logic is that over time if an industry is found to be exhibiting strong NPM, competition builds up in the space, driving NPM lower. As NPM reaches lower levels, weaker and non-serious players are ejected out, thereby again causing NPM to shore-up to reach the mean.

1. Explain why total asset turnover tends to be relatively constant.

Inherent nature of a firm’s line of business

Asset Turnover Ratio defined as Sales/Average Assets tend to be relatively constant. This is because both the numbers sales and average assets are relatively less volatile than the net profit margin. Between reporting periods, unless there has been a major event, both sales and assets do not vary much.

1. Explain why a jewelry store would be expected to have a high profit margin. How can this be so when jewelers are so competitive (four or five within shouting distance in every mall)?

A jewelry store would be expected to earn a higher margin despite competition. Firstly the nature of commodity that the jewellery stores deals in is not perishable in nature. This gives the seller holding power. A lot of the stock is built-up when the bullion prices are down, which may be sold when there is demand in the markets. In addition the nature of customers are high net-worth who like to buy the jewelry as an item of show-off. Hence, elasticity of demand is not very high. These factors enable the jewellers to charge a higher prices for their products.

1. Using the DuPont Identity, how would you describe the financial performance that would be expected from a supermarket chain (ignore EM component)?

Using the Dupont equation, a supermarket is expected to show the following financial performance:

Net profit margin (Net Profit/Sales) would be lower.  A supermarket is not adding value to product. It simply sells products over the counter and earns a miniscule percentage as profits.

Asset turnover (Sales/Assets) is high. The shortfall in profit margins is made-up by having a high asset turnover. Asset turnover measures the sales made per dollar of asset. The higher the turnover, the better it is. It indicates higher utilisation/efficiency of assets.