You Don’t Know if That is a Big Number

This post is not a big deal, but I did want to vent briefly about one of my pet peeves: Citing raw profit numbers as evidence that some corporation is making huge profits.

How often do you read a news story in which some journalist or activist makes a claim that XYZ Corporation is extremely profitable because they recently had $253.7 million (or some other big number) in profits? Such numbers, of course, tell us exactly nothing about how profitable XYZ Corporation is. Sure, $253.7 million is a lot of money to me, but I have no idea if it is a lot of money in this context. Furthermore, without a bunch of other information there is no way that I can tell if $253.7 million is a lot of money. One possibility might be to site revenue statistics to me. For examples, if they had profits of $253.7 million on revenues of $10 billion this means that they had a profit margin of about 2.6 percent which is not much to write home about. On the other hand, profits of $253.7 million on a $1 billion in revenues suggests a profit margin of something like 25 percent, which is pretty profitable. Of course, even looking at profit margins isn’t as probative of profitability as one might assume. One still has to ask the question of how much capital is at issue. For example, if you get $253.7 million on $1 billion in revenues, you have a nice looking profit margin of 25 percent. On the other hand, if there is $25 billion in capital invested in the business, then we are looking at a return of something like 1 percent on the capital, which isn’t really all that impressive. Of course, even this number doesn’t fully capture stuff like risk or contingent liabilities. This is why I get testy when some politician or pundit cites some impressively large number and then opines about how very, very profitable business X is. The truth of the matter, I suspect, is that the pundits and politicians have no idea whether or not business X is profitable. Scarier still, they probably have no idea that they have no idea how profitable business X is. It really bugs me.

Okay, I feel better for having gotten that off my chest.

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1 Response

  1. Ken says:

    Nate wrote: >>The truth of the matter, I suspect, is that the pundits and politicians have no idea whether or not business X is profitable. Scarier still, they probably have no idea that they have no idea how profitable business X is. It really bugs me.>>

    And it should bug us all.

    By a remarkable coincidence, just this morning I found this link on my other favorite blog, Marginal Revolution (economics stuff): http://sports.espn.go.com/espn/page2/story?page=simmons/100402

    This is Bill Simmons’ article on ESPN describing his late arrival to the world of Sabermetrics, which is the attempt to apply quantitative methods to better understanding of baseball. “Traditional” fans have railed against it, but the simple fact is that calculating batting average and counting RBI’s just isn’t enough.

    In the realm of economics, and particularly in evaluation of corporate performance, there is a seemingly endless proliferation of quantitative methods. Unlike baseball, where the sophisticated methods seem to be known only to a limited circle of “stathead geeks,” in economics the concepts, the computations, and the results, are all widely known and widely used.

    It’s only the “traditional fans” (i.e., the ones too lazy to learn what’s happening) who still cling to the oversimplifications. And it’s lame that the news media and the politicians are the ones most firmly planted in that “community of ignorance.”