“One-two-three, Oh that’s how elementary it’s gonna be …” — from “1-2-3” as recorded by Len Barry
Recently I read about a company that reported $3 billion in annual sales, but failed to make a profit for the third consecutive year. They must have encountered a lot of office expenses, right?
Big numbers confuse most of us. A fascinating recent article on this very subject in the Wall Street Journal referenced the latest U.S. budget proposal as an example of how large numbers create confusion. The most recent offering trims $2.7 billion from a $1.068 trillion budget.
Quickly, sans calculator, let’s estimate the percentage of this proposed reduction. What would we say? One percent? Five percent? Ten percent? More? Slicing $2.7 billion saves a lot of money, right?
Turns out, the $2.7 billion savings represents about one quarter of 1 percent of the previous year’s budget total. Just under $3 billion is a huge amount of money to most of us. Yet it’s a pittance when compared to the total overall budget. Transitioning from the world of tens, hundreds and thousands, where most of us operate on a daily basis, to the world of millions and billions takes some practice.
“We assume all these things are very natural, but they are highly abstract,” said Daniel Ansari, an investigator at the Numerical Cognition Laboratory at Western University in Ontario. “We can’t really perceive a million or a billion.”
But internalizing those differences is necessary for truly grasping the value of various investments. While our brains tend to lump big numbers together as all too-big-to-comprehend, putting numbers in increments we understand can serve as a powerful tool. Here’s the way my son describes it: $1 million buys you a beautiful house on a golf course; $1 billion buys you an NBA team.
Now, let’s consider the connection to investing. Let’s say you’re interested in purchasing a company that owns chain stores. You’re reading the financial statements and attempting to perform your due diligence before you buy the stock. But it’s common to run into the problem of trying to think in terms of billions of dollars.
Here’s a suggestion: divide all the relevant metrics like sales, cost of goods sold, operating expenses, interest and taxes paid and net income by the total number of stores. This simple reduction in the size of the dollars you’re working with can provide insight into the economics of a single “average” store.
The company may own 10,000 stores, but before attempting to analyze the financial picture of all these locations simultaneously, boil it all down and first determine if the “average” store is a good business. If it’s not, owning 9,999 more probably won’t be of interest to you.
Margaret R. McDowell, ChFC, AIF, author of the syndicated economic column "Arbor Outlook," is the founder of Arbor Wealth Management, LLC, (850-608-6121 — www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin.